Wednesday, September 12, 2012

Momentum + Bull market = Chocolate + Peanut butter?

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 3 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.

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:
  • Buy when Index is in an uptrend, defined as the index greater than the 50 day MA and the 50 day MA is greater than the 200 day MA.
  • Otherwise, hold cash.
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.

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.

Conclusion: Price momentum and bull markets go together like chocolate and peanut butter*.
* If you like that kind of thing.

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.  


keithpiccirillo said...

According to his definition fundamentals drive momentum traders, while trenders find what they feel is an appropriate buy point and lighten up losing position and advance when they gain. They may also get stopped out a lot more often. I pretty much nailed the silver bottom, and had one going in DRYS but stopped out when I set the stop too tight.
I enjoy chocolate and peanut butter, but only separately. :)

walt said...

Good work Cam. I was a beginning investor in 1970-1986: that's half a career. For someone starting a family that was ugly.

Going forward, I'm counting on you to ring your bell at turning points (as you have been).

Phil said...

Great post as usual! Just a quick question regarding how your "momentum relative returns" : what is the frequency of your adjustments (daily, weekly...) for the momentum portfolio and for the benchmark. I was trying to reproduce these results, but couldn't get quite the same. thx !

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