Using Momentum in Emerging Markets

 

Momentum investing relies on inertia: the directional tendency of investment performance. What has been doing well will tend to continue doing well; what is doing badly will tend to continue doing badly.  Momentum investors seek to catch long rising trends, and quit losing trades. The famous classical economist, David Ricardo, summed it up well in 1838 when he said what has become a mantra for momentum investors: “Cut your losses; let your profits run on.”

An elite cohort of investors have embraced this style of investing, including Richard Driehaus, Paul Tudor Jones, George Soros and Stanley Druckenmiller, some working purely on a technical basis, others combining momentum with fundamentals.

Like all anomalies in efficient markets, the momentum factor creates excess returns because of behavioral reasons. Successful investors learn to exploit systematic and predictable irrational human behavior. A typical trend evolves as follows:

Phase 1- Anchoring and under-reaction- Prices initially lag fundamentals, allowing early movers to position themselves well ahead of the crowd.

Phase2- Herding  and over-reaction – As prices start moving higher, investors join the heard, eventually over-reacting.

In an effort to show how common investors, without the trading smarts or resources of a Soros, could successfully use momentum to enhance returns, Gary Antonacci proposed  “Dual Momentum Investing,” in an article and subsequently a book.

Antonacci’s Global Equities Momentum (GEM) portfolio builds a portfolio with three assets: U.S. stocks, international stocks and U.S. bonds. For the retail investor he recommends using low-cost ETFs: for example, VOO for U.S. stocks; VEU for non-U.S. stocks and AGG for U.S. aggregate bonds.

Antonacci named his system “Dual Momentum” because he uses both relative momentum (the measure of the performance of an asset relative to another asset) and absolute momentum ( the measure of performance relative to the risk-free rate – absolute excess return.)

To keep the process very simple to implement, he used a 12-month look-back period and an easy to execute buy and sell system.

  • Every month the investor places all funds in the equity ETF that has the best 12-month performance relative to the other equity ETFs, unless the absolute performance is worse than the return of six-month U.S. Treasuries (as measured by BIL ETF).
  • If absolute performance is below the BIL ETF, then the investor places all funds in AGG, the aggregate bond index.

The simple process aims to position the investor to benefit from long rising trends while avoiding drawdowns. The process is fully automated, eliminating human behavioral reactions.

Antonacci looks at results from 1974 to October 2013. During this period, the portfolio was invested 41% of the time in U.S. stocks, 29% in international stocks and 30% in U.S. bonds. The portfolio was switched 1.3 times per year.

The portfolio outperformed the global benchmark (MSCI All Country World Index – ACWI) by 7.6% annually for the period, with consistent outperformance every decade. It accomplished this with much lower volatility (standard deviation of GEM is 12.64% vs. 15.56%.) More importantly, the maximum drawdown (decline in the value of the fund) was 17.8%, vs. 60% for ACWI.

Antonacci does not recommend using emerging markets in his GEM portfolio, beyond what is already included in the ACWI. He claims that emerging markets have become more correlated in recent years and do not add value.

To evaluate this claim, I ran Antonocci’s system, including emerging markets as a third asset class in addition to U.S. stocks and the MSCI developed market Index. I suspected that Antonacci’s view on the high correlation was influenced by the very high down-side correlation during the 2008-09 financial crisis. Historically, correlations have been relatively low, particularly on the upside, and the high volatility of emerging markets should be exploitable by the GEM process.

From 1999 to October 2017 (admittedly a short period) the GEM Plus EM portfolio produced impressive results, as shown below. The investments are implemented using the SPY ETF (S&P), VTMGX (EAFE), and VEIEX (EM).

  • The expanded GEM portfolio generated significant excess return by riding long dominant upswings for EM and the S&P and avoiding downturns by  reallocating to U.S. bonds. By doing this it avoided massive drawdowns in the early 2000s and during the financial crisis of 2008-09. Given the very high correlation that markets have shown during downturns, the option of holding U.S. bonds for 18% of the time-period reduced the funds maximum drawdown dramatically.
  • Switches from one asset to another occured 1.49 times per year, compared to 1.3 times per year for Antonacci’s portfolio. This is because of the addition of a third asset.

These momentum strategies seem well suited for the market environment of the past decades which has been marked by large drawdowns and sustained trends. They also provide downside protection from the very high current asset prices around the world.  For tax-shielded investors, the advantages are clearly compelling, somewhat less so for taxed investors. The strategy would work poorly if market leadership were to change frequently, creating false signals.

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