After our previous write up regarding the idea of combining momentum and low volatility into a portfolio, we had a few requests asking about the concept of combining momentum and value. As long time Dorsey Wright readers know, while we absolutely believe momentum can work as a stand-along strategy in a portfolio, combining momentum with a value based strategy does have certain advantages. As is the case with low volatility, a value based approach can also typically be thought of as a reversion to the mean type of trade as market participants seek value in underperforming stocks or asset classes. Obviously, a momentum based approach is focused on finding stocks that have outperformed their peers over a certain period (ex. 12 month trailing), hoping those strong trends continues to maintain leadership in the market.
Here is a brief summary of each strategy side by side. Note we are using total return for the RPV (Pure Value) and SPX (Benchmark). As shown below, PDP (Momentum) outperforms both RPV and SPX over the allotted time frame in this study, but not without slightly higher volatility. We can also see a number of years in which momentum and value have substantially different performance numbers. Let’s take this a step further and dive into some of the details on the correlation of excess returns between the two strategies.
As we pointed out in our previous post, the correlation of excess returns between low volatility and momentum came in at roughly -.70. Given what we mentioned about the underlying theme of momentum investing (trend following) while compared to value investing (mean reversion), it’s logical to think a similar type of figure would exist between these two strategies as well. The table below shows a comparison of annual returns using the time period 1998 and 2015 in which the correlation of excess returns between value and momentum comes out to be -.50. A few of the outlier years to take note of which contain major differences in performance are 1998 – 2002, 2007, 2009, and finally 2015. The main concept again being not only does having the ability to rotate or combine these two factor based strategies help improve performance; it also helps in reducing volatility. (click on below graphic to enlarge)
PDP inception date: March 1, 2007, RPV inception date: March 3, 2006 – data prior to inception is based on a back-test of the underlying indexes. Please see the disclosures for important information regarding back-testing. PDP returns do not include dividends. Returns do not include all potential transaction costs. Past performance is not indicative of future results. Potential for profits is accompanied by possibility of loss.
Let’s take this a step further to answer the one question that is usually on most market participants minds. “How do I implement these products into a portfolio for my clients?” The number of possibilities is endless but to keep things simple we set up a “static allocation” model that rotates through a number of different portfolio’s starting with a 90% PDP/10% RPV and all the way to 10% RPV/90% PDP during our time period stated above. This gives a very detailed description of how each one of these portfolios would have performed on a cumulative, annual, and risk –adjusted (volatility) basis. However, what if we could improve on these returns and be more flexible in our allocations. We know that often times combing some sort of trend following proxy (typically a moving average) in addition to a stand-alone momentum strategy can often times help improve these numbers. This will be part of our final discussion. (click on below graphic to enlarge)
Over time, it’s typically been the case that a momentum/trend following based strategy (assuming a long only portfolio) tends to perform better while the SPX is above its 200 day moving average. On the flip side, a choppy market with a lack of sustained leadership (which can favor a value based strategy) is more likely to presents itself when the SPX is below its 200 day MA. This is not always the case but over the years research has shown that the 200 day moving average is often considered a reliable proxy for a risk on/risk off environment. The below table compares a model we have created using a 200 day moving average as a risk proxy to determine whether or not we will invest in a momentum (PDP) or value (RPV). We thought it would be interesting to take these allocations to the extreme, relying on a 100% momentum based strategy when the SPX is above its 200 day MA, while flipping to Value when the SPX is below its 200 day moving average. Our momentum/trend following model which incorporated the 200 day risk proxy averaged just over 10% annual return, while minimizing volatility to just 21%. Comparing these towards using PDP or RPV as stand-alone vehicles as was in table 1, we can see the benefits when it comes to having access to both products. (click on below graphic to enlarge)
PDP inception date: March 1, 2007, RPV inception date: March 3, 2006 – data prior to inception is based on a back-test of the underlying indexes. Performance of the switching strategy is the result of back-testing. Back-tested performance results have certain limitations. Such results do not represent the impact of material economic and market factors might have on an investment advisor’s decision-making process if the advisor were actually managing client money. Back-testing performance also differs from actual performance because it is achieved through retroactive application of a model investment methodology designed with the benefit of hindsight. PDP returns do not include dividends. Returns do not include all potential transaction costs. Past performance is not indicative of future results. Potential for profits is accompanied by possibility of loss.
As this paper shows, there are a number of ways to combine both momentum and value into a portfolio. For those investors willing to accept slightly higher volatility to achieve higher returns, a portfolio with a larger allocation towards momentum certainly is favorable. The same can be true for those investors looking to low annualized volatility who might not be as concerned about achieving a certain level of excess return. Finally, we showed adding a trend following proxy (the 200 day moving average) can help aide in substantial performance over the benchmark (SPX), and also help achieve better risk management when using a momentum or value based strategy as a stand-alone vehicle.
Performance data for the model is the result of hypothetical back-testing. Performance data for RPV prior to 03/01/06 and PDP prior to 3/01/2007 is the result of backtested underlying index data. Investors cannot invest directly in an index, like the SPX. Indexes have no fees. Total return figures are used in RPV and SPX calculations. Back-tested performance is hypothetical (it does not reflect trading in actual accounts) and is provided for informational purposes to illustrate the effects of the strategy during a specific period. Back-tested performance results have certain limitations. Back-testing performance differs from actual performance because it is achieved through retroactive application of an investment methodology designed with the benefit of hindsight. Model performance data as well as back-tested performance do not represent the impact of material economic and market factors might have on an investment advisor’s decision making process if the advisor were actually managing client money. Past performance is not indicative of future results. Potential for profits is accompanied by possibility of loss.