Why Does Dual Momentum Outperform?
Those who have read my momentum research papers, book, and this blog should know that simple dual momentum has handily and consistently outperformed buy-and-hold. The following chart shows the 10- year rolling excess return of our popular Global Equities Momentum (GEM) dual momentum model compared to a 70/30 S&P 500/U.S. bond benchmark [1] Results are hypothetical, are NOT an indicator of future results, and do NOT represent returns that any investor actually attained. Indexes are unmanaged, do not reflect management or trading fees, and one cannot invest directly in an index. Please see our Performance and Disclaimer pages for more information. GEM has always outperformed this benchmark and continues to do so now, although the amount of outperformance has varied considerably over time. In 1984 and 1997-2000, those who might have guessed that dual momentum had lost its mojo saw its dominance come roaring right back. In Chapter 4 of my book, I give a number of the explanations why momentum in general has worked so well and has even been called the “premier anomaly” by Fama and French. Simply put, reasons for the outperformance of momentum fall into two general categories: rational and behavioral. In the rational camp are those who believe that momentum earns higher returns because its risks are greater. That argument is harder to accept now that absolute momentum has clearly shown the ability to simultaneously provide higher returns and reduced risk exposure. The behavioral explanation for momentum centers on initial investor underreaction of prices to new information followed later by overreaction. Underreaction likely comes from anchoring, conservatism, and the slow diffusion of information, whereas overreaction is due to herding (the bandwagon effect), representativeness (assuming continuation of the present), and overconfidence. Price gains attract additional buying, which leads to more price gains. The same is true with respect to losses and continued selling. The herding instinct is one of the strongest forces in nature. It is what allows animals in nature to better survive predator attacks. It is built in to our brain chemistry and DNA as a powerful primordial instinct and is unlikely to ever disappear. Representativeness and overconfidence are also evident and prevalent when there are strong momentum-based trends.Investors’ risk aversion may decrease as they see prices rise and they become overconfident. Their risk aversion may similarly increase as prices fall and investors become more fearful. These aggregate psychological responses are also unlikely to change in the future. One can easily make a logical argument for the investor overreaction explanation of the momentum effect with individual stocks. Stocks can have high idiosyncratic volatility and be greatly influenced by news related items, such as earnings surprises, management changes, plant shutdowns, employee strikes, product recalls, supply chain disruptions, regulatory constraints, and litigation. A recent study by Heidari (2015) called, ” Over or Under? Momentum, Idiosyncratic Volatility and Overreaction “, looked into the investor under or overreaction question with respect to stocks and found evidence that supported the overreaction explanation as the source of momentum profits, especially when idiosyncratic volatility was high. A number of economic trends, not just stock prices, get overextended and then have to mean revert. The business cycle itself trends and mean reverts. Since the late 1980s, researchers have known that stock prices are long-term mean reverting [2]. Mean reversion supports the premise that stocks overreact and become overextended, which is what leads to their mean reversion. We will show that overreaction, in both bull and bear market environments, provides a good explanation for why dual momentum has worked so well compared to buy-and-hold. Dual Momentum Performance Earlier we posted Dual, Relative, & Absolute Momentum , which highlighted the difference between dual, relative, and absolute momentum. Here is a chart of our GEM model and its relative and absolute momentum components that were referenced in that post. GEM uses relative momentum to switch between U.S. and non-U.S. stocks, and absolute momentum to switch between stocks and bonds. Instructions on how to implement GEM are in my book, ‘ Dual Momentum Investing: An Innovative Strategy for Higher Returns with Lower Risk’ . Results are hypothetical, are NOT an indicator of future results, and do NOT represent returns that any investor actually attained. Indexes are unmanaged, do not reflect management or trading fees, and one cannot invest directly in an index. Please see our Performance and Disclaimer pages, linked previously, for more information. Relative momentum provided almost 300 basis points more return than the underlying S&P 500 and MSCI ACWI ex-US indices. It did this by capturing profits from both indices rather than from just from a single one. We can tell from the above chart that some of these profits were due to price overreaction, since both indices pulled back sharply following strong run ups. Even though relative momentum can give us substantially increased profits, it does nothing to alleviate downside risk. Relative momentum volatility and maximum drawdown are comparable to the underlying indices themselves. However, we see in the above chart that absolute momentum applied to the S&P 500 created almost the same terminal wealth as relative momentum, and it did so with substantially less drawdown. Absolute momentum accomplished this by side stepping the severe downside bear market overreactions in stocks. As with relative momentum, there is ample evidence of price overreaction here, since there were sharp rebounds from oversold levels following most bear market lows. We see that overreaction comes into play twice with dual momentum. First, is when we exploit positive overreaction to earn higher profits from the strongest index selected by relative momentum. Trend following absolute momentum can help lock in these overreaction profits before the markets mean revert them away. Second is when we avoid negative overreaction by standing aside from stocks when absolute momentum identifies the trend of the market as being down. Based on this synergistic capturing of overreaction profits while avoiding overreaction losses, dual momentum produced twice the incremental return of relative momentum alone while maintaining the same stability as absolute momentum. We should keep in mind that stock market overreaction, as the driving force behind dual momentum, is not likely to disappear. Distribution of Returns Looking at things a little differently, the following histogram shows the distribution of rolling 12-month returns of GEM versus the S&P 500. We see that GEM has participated well in bull market upside gains while truncating left tail risk representing bear market losses. Dual momentum, in effect, converted market overreaction losses into profits. Market Environments We can also gain some insight by looking at the comparative performance of GEM and the S&P 500 during separate bull and bear market periods. BULL MKTS BEAR MKTS Date S&P 500 GEM Date S&P 500 GEM Jan 71-Dec 72 36.0 65.6 – – – Oct 74-Nov 80 198.3 103.3 Jan 73-Sep 74 -42.6 15.1 Aug 82-Aug 87 279.7 569.2 Dec 80-Jul 82 -16.5 16.0 Dec 87-Aug 00 816.6 730.5 Sep 87-Nov 87 -29.6 -15.1 Oct 02-Oct 07 108.3 181.6 Sep 00-Sep 02 -44.7 14.9 Mar 09-Nov15 225.7 89.4 Nov 07-Feb 09 -50.9 -13.1 Average Return 277.4 289.9 Average Return -36.9 3.6 Results are hypothetical, are NOT an indicator of future results, and do NOT represent returns that any investor actually attained. Indexes are unmanaged, do not reflect management or trading fees, and one cannot invest directly in an index. Please see our Performance and Disclaimer pages, linked previously, for more information. During bull markets, GEM produced an average return somewhat higher than the S&P 500. This meant that relative momentum earned more than absolute momentum gave up on those occasions when absolute momentum exited stocks prematurely and had to reenter stocks a month or several months later [3]. Relative momentum also overcame lost profits when trend-following absolute momentum temporarily kept GEM out of stocks as new bull markets were just getting started. Absolute momentum on its own can lag during bull markets, but relative momentum can alleviate the aggregate bull market underperformance of absolute momentum. Relative and absolute momentum therefore complement each other well in bull market environments. What really stand out though are the average profits that GEM earned in bear market environments when stocks lost an average of 37%. Absolute momentum, by side stepping bear market losses, is what accounted for much of GEM’s overall outperformance. Large losses require much larger gains to recover from those losses. For example, a 50% loss requires a subsequent 100% gain to get back to breakeven. By avoiding large losses in the first place, GEM has avoided being saddled with this kind of loss recovery burden. Warren Buffett was right when he said that the first (and second) rule of investing is to avoid losses. Increased profits through relative strength and loss avoidance through absolute momentum are only half the story though. Avoiding losses also contributes greatly to investor peace of mind and helps prevent us from becoming irrationally exuberant or uncomfortably depressed, which can lead to poor timing decisions. Not only does dual momentum help capture overreaction bull market profits and reduce overreaction bear market losses, but it gives us a disciplined framework to keep us from overreacting to the wild vagaries of the market. [1] GEM has been in stocks 70% of the time and in aggregate or intermediate government/credit bonds around 30% of the time since January 1971. See the Performance page of our website for more information. [2] See Poterba and Summers (1988) or Fama and French (1988). [3] Since January 1971, there have been 9 instances of absolute momentum causing GEM to exit stocks and then reenter them within the next 3 months, foregoing an average 3.1% difference in return.