By
Cam Hui
:
There has been a fair amount of research devoted to the effects
of price momentum. I came upon a paper by a team of researchers at
Cass Business School entitled
The Trend is Our Friend: Risk Parity, Momentum and
Trend Following in Global Asset Allocation
(h/t
Mebane Faber
). The abstract reads:
We examine the effectiveness of applying a trend following
methodology to global asset allocation between
equities,bonds,commodities and real estate.The application of
trend following offers a substantial improvement in risk-adjusted
performance compared to traditional buy-and-hold portfolios. We
also find it to be a superior method of asset allocation than
risk parity. Momentum and trend following have often been used
interchangeably although the former is a relative concept and the
latter absolute. By combining the two we find that one can
achieve the higher return levels associated with momentum
portfolios but with much reduced volatility and drawdowns due to
trend following. We observe that a flexible asset allocation
strategy that allocates capital to the best performing
instruments irrespective of asset class enhances this
further.
The academic researchers focuses primarily on the combination of
price momentum factors with trend following models, but I came at
it another way. Why does price momentum work?
My own momentum study
I reproduced the research of the Cass researchers but using a
six-month price momentum factor (they used 12 months, but the
results were similar) to form a portfolio of the top three sectors
using sector ETFs within the 10 SPX sectors and benchmarking their
performance against an equal-weighted benchmark of the 10 sectors.
The 10 sectors are:
-
Consumer Discretionary
-
Consumer Staples
-
Energy
-
Financials
-
Health Care
-
Industrials
-
Materials
-
Technology
-
Telecom
-
Utilities
The study was conducted for the period from December 1999 to
August 2012. The chart below shows the relative returns of the
momentum portfolio against the equal-weighted benchmark.
(click to enlarge)
Price momentum worked over the study period, but its relative
performance is highly volatile. In particular, price momentum
returns were particularly negative during bear markets.
Trend following models as a bull/bear market
filter
If price momentum performs poorly as a selection factor during bear
markets, then there a simple technique of filtering out prolonged
bear markets. The technique is called trend-following.
Josh Brown
recently made some sensible comments about trend following systems
as a source of risk control [emphasis added]:
A lot of guys who run money tactically make some use of the
50-day and 200-day moving average crossovers as their signals to
buy or sell whole chunks of equity exposure for the clients.
Which is good, not great. We pay attention to some of that but we
certainly aren't living and dying by it absent other inputs.
There are no fool-proof timing signals that "always work" - at
least that I'm aware of -
but even having any discipline and systematic risk management
approach is often better than none at all. Some of the simpler
moving average crossovers have been shown to have saved people a
lot of aggravation in 2008 (they had you out of the way when
applied to the major indices, for example) but they don't always
get you back in when you should be
.
They also are plagued by false signals and headfakes - just like
any other system.
To demonstrate, I applied the following 50 and 200 day moving
average trend following system to the SPX from 1950 to the present,
using the following rules:
I made a number of simplifying assumptions:
-
Signals are generated at the end of day
-
Trades are done at next day's closing price
-
There are no trading costs
-
No dividends are paid
-
0% paid on cash
The chart below shows the results of this simulation. The blue
line represents the cumulative return of the buy-and-hold benchmark
and the red line the trend following system. The trend following
system didn't beat the returns of the buy-and-hold benchmark, but
it controlled risk better. The major benefit of these models is
they allow better risk control - they allow the investor to avoid
the ugly drawdowns that accompany major bear markets.
(click to enlarge)
In effect, these systems are filters for bull and bear markets.
Investors who use them can cut losses quickly and allow winners to
run.
Price momentum in trended markets
If price momentum acts well in bull markets and badly in bear
markets, can using a 50/200-day moving average trend following
system help?
The answer is an emphatic yes! The chart below shows the
relative returns of the price momentum model as applied to the 10
sectors described above, when the market is in an uptrend, neutral
trend and downtrend. As you can see, price momentum works
beautifully for sector selection in trended up markets; results
were slightly positive in neutral trends; and negative in
downtrends.
(click to enlarge)
Conclusion:
Price momentum and bull markets go together like chocolate and
peanut butter*.
*If you like that kind of thing.
Disclaimer
: Cam Hui is a portfolio manager at Qwest Investment Fund
Management Ltd. ("Qwest"). This article is prepared by Mr. Hui as
an outside business activity. As such, Qwest does not review or
approve materials presented herein. The opinions and any
recommendations expressed in this blog are those of the author and
do not reflect the opinions or recommendations of Qwest.
None of the information or opinions expressed in this blog
constitutes a solicitation for the purchase or sale of any security
or other instrument. Nothing in this article constitutes investment
advice and any recommendations that may be contained herein have
not been based upon a consideration of the investment objectives,
financial situation or particular needs of any specific recipient.
Any purchase or sale activity in any securities or other instrument
should be based upon your own analysis and conclusions. Past
performance is not indicative of future results. Either Qwest or
Mr. Hui may hold or control long or short positions in the
securities or instruments mentioned.
See also
Weekly Outlook For October 1: 4 Stocks To Trade,
What's Next For The Market
on seekingalpha.com