By Timothy Strauts
Last week, my colleague Alex Bryan wrote an article titled
"Does Momentum Investing Work?"
Alex's article offers an introduction to momentum drawing on a
growing body of academic research on the topic to examine its
potential sources, how it might be exploited, and the obstacles
facing investors seeking to capitalize on this phenomenon. If you
haven't read his piece, I recommend doing so before reading any
further as it will serve as the basis for this article.
Trying to actively harness momentum at the level of individual
stocks will result in a portfolio with high volatility, high
transaction costs, and a large number of positions that can border
on unwieldy. However, by swapping stocks with exchange-traded
funds, we can mitigate many of the issues that complicate
implementing a momentum strategy with just stocks.
Market-timing is a dirty (compound) word. The efficient-markets
hypothesis holds that market-timing is futile. Conventional wisdom
says that not only is market-timing nearly impossible, but many
investors (and retail investors in particular) seem to have
forgotten to wind their watches and exhibit "buy high, sell low"
behavior. Momentum, the tendency for prices to trend, is one of the
most reliable ways to extract returns from naive investors who
engage in "reverse" market-timing.
Momentum can take many forms. Two particular forms of momentum
can be fairly easily mimicked with
: time series momentum and asset class momentum. Next, we'll
discuss each "flavor" of momentum and walk through some
hypothetical portfolios constructed with ETFs that seek to exploit
Time Series Momentum
The simple moving average, or SMA, is a common technical indicator.
As its name indicates, it's calculated by averaging the past prices
for an asset over a specified time period. Typical technical
trading strategies involve owning assets when they are trading at
prices above their 200-day SMA and holding cash when they trade
below their SMA.
Perhaps the best known proponent of SMA-based timing is Mebane
Faber, whose 2007 paper,
"A Quantitative Approach to Tactical Asset
further popularized SMA-based market-timing among practitioners.
Faber found that employing 200-day SMA-based timing reduced
drawdown and volatility and improved absolute returns across an
array of diverse asset class benchmarks such as the United States
stock market, the MSCI EAFE Index, the Goldman Sachs Commodity
Index, a REIT Index, and 10-year Treasuries.
In 2011, we performed our own study of moving-average-based
timing indicators. We tested 83 different indexes that encompassed
U.S. and foreign stocks, bonds, and commodities. Some of the
indexes went back as far as 1926. The results were eerily
consistent. In almost every asset class SMA-based timing strategies
reduced drawdowns and volatility while maintaining or improving
absolute returns. Consistent with the behavioral explanation for
momentum, the SMA-based timing worked best in less-efficient,
more-volatile asset classes. Look-back periods ranging from 10 to
12 months seem to provide the most consistent performance without
A startling example of how employing time series momentum can
improve a portfolio is Greece. Since March 1992, the MSCI Greece
Index has returned negative 2.0% annualized, with most of this poor
performance explained by its 93% drawdown since 2007. Meanwhile, a
12-month SMA-based timing strategy would have produced an
annualized return of 11.9%. It would have been difficult to imagine
five years ago that Greece would be on the brink of default today,
but the strategy would've gone to cash in February 2008 and avoided
the ensuing bloodbath.
Asset Class Momentum
Asset class momentum differs from the type of momentum examined by
academia in one key regard. Most academic research employs a 12-1
momentum strategy, which looks at returns over the trailing
12-month period, excluding the most recent month. Stocks tend to
show a short-term reversal in the most recent month, so it is
excluded. However, when examining momentum at the asset class level
this short-term reversal disappears, so it's not necessary to
remove the most recent month's returns.
As mentioned earlier, ETFs may be a more-efficient tool for those
looking to implement a momentum strategy. What follows are two
examples of momentum-driven model portfolios taken from the
newsletter. Newsletter editor and ETF strategist Sam Lee tracks six
different model portfolios that incorporate elements of both time
series and asset class momentum. The portfolios use a 12-month SMA
and 12-month total returns as their two momentum indicators. It is
important to note that the portfolio performance shown below does
not include the effects of taxes or transaction costs.
U.S. Sector Momentum Strategy
The above table lists the eligible holdings for the U.S. Sector
Momentum strategy. On a monthly basis, each ETF's current price is
compared with its 12-month SMA. If it's trading below its 12-month
SMA, it is excluded from further consideration. The remaining ETFs
are sorted by their trailing 12-month total returns. The top three
ETFs from this second sort are equally weighted in the portfolio.
If there are fewer than three ETFs trading above their 12-month
SMA, the portfolio will hold cash in combination with the one to
two ETFs meeting this first criteria. If no ETF qualifies, the
portfolio will be entirely in cash.
The sector momentum strategy has very high turnover. State
Street Select Sector SPDRs are some of the most-liquid funds in the
market, so trading with market orders should not be a problem. The
strategy will likely generate substantial short-term capital gains
as it will make between 15 and 20 trades per year.
(click to enlarge)
Global Momentum Strategy
The eligible portfolio holdings for the global momentum strategy
are listed in the table above. On a monthly basis, each ETF's
current price is compared with its 12-month SMA. If it is trading
below its 12-month SMA, it is excluded from further consideration.
The remaining ETFs are sorted by 12-month total returns. The
portfolio picks the top two ETFs resulting from this second sort.
If only one ETF is eligible, the portfolio will hold that ETF and
cash in equal amounts. If no ETF qualifies, the portfolio will be
entirely cash. The custom benchmark we have created for this
strategy is an equal-weighted portfolio of the eligible
The global momentum strategy is best suited as a satellite
investment strategy within the confines of a tax-sheltered account.
Most investors will be uncomfortable holding such a concentrated
portfolio that only owns one or two ETFs at a time. In trendless
markets, the strategy will make many trades without much success.
One implementation method could be to invest 80% of assets in a
diversified core portfolio and allocate 20% to the global momentum
strategy. This strategy typically makes between five and 10 trades
(click to enlarge)
The two model portfolios described above use ETFs in an attempt
to exploit momentum. Over the period examined, both have generated
high relative returns with below-average risk. In the case of the
global momentum strategy, the blending of time series momentum and
asset class momentum appears to offer a particularly compelling
combination. However, there are periods when these strategies
underperform. In those periods of underperformance it may be
difficult to adhere to this discipline. As is the case with many
funds or strategies that may be temporarily out of favor, many
investors tend to throw in the towel at exactly the wrong time--the
exact sort of behavior that might explain why momentum exists! It's
also important to note that the frequent trading inherent in
implementing these strategies will increase trading costs and
reduce tax efficiency. Investors considering implementing such
strategies should do so within the confines of a tax-deferred
account, ideally one offering low-cost (or even free) trades.
Morningstar, Inc. licenses its indexes to institutions for a
variety of reasons, including the creation of investment products
and the benchmarking of existing products. When licensing indexes
for the creation or benchmarking of investment products,
Morningstar receives fees that are mainly based on fund assets
under management. As of Sept. 30, 2012, AlphaPro Management,
BlackRock Asset Management, First Asset, First Trust, Invesco,
Merrill Lynch, Northern Trust, Nuveen, and Van Eck license one or
more Morningstar indexes for this purpose. These investment
products are not sponsored, issued, marketed, or sold by
Morningstar. Morningstar does not make any representation regarding
the advisability of investing in any investment product based on or
benchmarked against a Morningstar index.
Your Portfolio Can Be All American