Tag Archives: ideas

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.

Time

Can you teach me ’bout tomorrow And all the pain and sorrow running free ‘Cause tomorrow’s just another day And I don’t believe in time Hootie & The Blowfish – Time Just a few days after writing our last letter about the warning sign that the high-yield market was flashing, Third Avenue went and closed an open-ended mutual fund to redemptions because it, essentially, couldn’t find reasonable bids for its bonds. In the aftermath, some commentators have noted that this fund was an exception, because its portfolio was particularly risky, made up of really low-quality bonds, and that it wasn’t symptomatic of larger issues in high-yield. I kinda agree and disagree. The issue was clearly that what they owned was a bunch of dreck, bottom-of-the-barrel type stuff, in a structure that really shouldn’t own such things. They forgot one of the key risk factors in managing money – time. The issue of time is often recast as one of a liquidity mismatch – owning assets that are less liquid than the liquidity terms offered to the investors in the structure. Mutual funds offer daily liquidity, which is great for assets like stocks and government bonds that have deep and liquid markets. Low-quality junk bonds aren’t quite as good a fit – a much better fit would be closed-end funds, where there are no redemptions, or in a private equity type fund of the sort that Oaktree and others run. But owning them in a regular retail mutual fund? Not a good idea. Is this going to be a systemic problem? Probably not. It appears that a lot of the mutual funds that own high-yield bonds only have portions of their funds in them, or, even better, are closed-end. Interestingly, many closed-end funds run by decent managers are trading for extremely deep discounts to NAV currently, and probably are good buys here. Our fund has been buying a few of these in the past week. Closed-end funds don’t have to worry about this liquidity element of time. However, another asset that is often confused with closed-end funds definitely does – ETFs. Time the past has come and gone The future’s far away And now only lasts for one second, one second Hootie & The Blowfish – Time ETFs have been hailed as the savior of retail investors. Some claim ETFs eliminate the risks in investing alongside other investors, whose time horizons may not match your own. In the case of Third Avenue, this issue was made clear by the fact that those who sold early realized a much better return than those who sold later, because Third Avenue was able to sell its better-quality bonds to redeem them. But ETFs suffer from the same problem. They have investors who can not only redeem daily, they can redeem at any time throughout the day as well. Amazingly, The Wall Street Journal published an article on the front of its Business and Finance section yesterday that is 100% wrong. Very wrong. Incredibly, I can’t believe this got published wrong. In it, Jason Zweig, who writes their weekly Money Beat column, states that ETF managers don’t have to sell their holdings to meet redemptions. Instead, they give a prorata share of those holdings to ETF dealers called authorized participants (APs), who in return give the ETF back some of its shares. This part is correct. But what Zweig misses completely, and I really don’t know how he does, is that the APs then turn around and sell those securities. APs are not in the business of just holding onto whatever the ETF manager gives them. Zweig says, “The ETF doesn’t have to fan the flames of a fire sale by dumping its holdings into a falling market.” Well, actually, it does. APs are in the business of arbitraging, for very small amounts of money, the differences between the price at which the ETF trades and the underlying value of its assets. That is why ETFs have to publish their holdings daily. It is why ETFs that invest in less-liquid assets will trade with a higher bid-ask spread. It’s why – oh man, it’s why a lot of things. But one thing ETFs are not are closed-end funds with an unlimited time horizon. They are a fund with an even shorter redemption time period than regular mutual funds. And yet, The Wall Street Journal has it completely backwards. Amazing. Time why you punish me Like a wave bashing into the shore You wash away my dreams Hootie & The Blowfish – Time But there is a more subtle, and more pernicious, aspect of the time factor in investing. That is the mismatch between investor expectations and time horizons for returns on the underlying investments. Different investors have different time horizons of course, but I’ve found in the more than 20 years I’ve been investing that what people say their time horizon is and what it really is are very different things. For all of its smug insularity and inability to hire women or minorities , one thing venture capital has gotten right is matching the duration of its investors with the duration of its investments. Investors in venture capital funds are conditioned to expect the investments to both take a long time to payoff and often not work out. It is a lesson that most retail investors miss. Instead, retail investors say they are “long-term” investors, when in reality they are generally uninterested investors. Until, suddenly, they are very interested – at which point they usually panic. This panic creates a selloff that punishes those investors who thought they had a lot of time to let their investments grow and generate the returns they expected, at least on a marked-to-market basis. This sell-off then triggers fear of further losses in investors who thought they owned “safe” assets, or “liquid” assets, so they sell too, which leads to a downward spiral. This is the contagion effect we’ve discussed here previously. It’s being exacerbated by the destruction occurring in many retail investor portfolios, because they, despite all the clear warning signs, chased yield instead of total return in recent years. In a world of low interest rates, they looked at the yields being paid by MLPs, private REITs, BDCs, and other yield vehicles and decided that getting a high current income was so important that they invested in companies or funds they didn’t really understand. They were happy, so long as prices were going up and they were getting paid. But now that prices are going down, often dramatically, they are realizing that there is no such thing as return without risk, that their tolerance for volatility is lower than they thought, and that their time horizon for their investments is shorter than they thought. Not a good combination. Time why you walk away Like a friend with somewhere to go You left me crying Hootie & The Blowfish – Time In my experience, mutual fund boards are no different in their short-termism than retail investors, and in some ways are worse. They get regular reports showing how the funds under their purview have performed on monthly, quarterly, yearly and 3-5 year time horizons. Usually there is a 10-year comparison as well, but it is routinely ignored as not relevant, as most investors ignore it too. These fund boards will harshly question any manager that dares to deviate from their benchmark, even for good reasons, and even if it is just to hold more cash during times of market excess. A mutual fund manager may well believe that the bonds or stocks it holds are overvalued, but be unable to do anything about it since they are, for the most part, supposed to be fully invested at all times. This means that even if the manager fully believes that the most prudent course of action would be to sell and hold cash, he or she generally won’t, because making a market bet is a quick way to find yourself looking for another job. Therefore, when markets do sell off, mutual funds are generally not a good source of buying support – they have to sell something to buy something. Twenty or thirty years ago, fund managers had a lot more flexibility to use their judgement about markets and fund positioning, but today much of that flexibility is gone. Similarly, another source of market buying during times of panic used to be the investment banks and bond dealers, but Dodd-Frank has killed that off. Today, dealers are just middle-men – they are not allowed to position securities on their books. When I interviewed at Goldman Sachs (NYSE: GS ) after business school, the interview took place on the equity trading floor, where I was surrounded by hundreds of traders and salesmen. Today, Goldman has less than 10 traders making markets in U.S. stocks. Think they are making a big two-way market anymore? I don’t think so either. Time without courage And time without fear Is just wasted, wasted Wasted time Hootie & The Blowfish – Time One of them main advantages of hedge funds is that their investors, for the most part, understand that in order to make money, you need to be willing to tolerate some volatility and wait out the market’s recurring cycles. (Full disclosure: I manage a hedge fund, and am biased toward the structure). Another advantage is that, because their managers are granted flexibility to go both long and short, and to hold cash, they can take advantage of these market dislocations to buy good assets at distressed prices. They can cover shorts, sell one asset to buy another, or use leverage to buy when others panic. Granted, some managers will get their markets wrong, and fail spectacularly, but that doesn’t mean that overall the industry is flawed. It’s simply part of being in the markets – not everyone can be right all the time, and those that fail to manage their leverage and risk exposures will be carried out of the arena accordingly. But the impression that hedge funds are all the same, that they all are rapid day-traders (some are, some aren’t) misses the point that they are one of the few sources of buying support left in the markets today. They are, as a group, the only ones that have both the time and ability to step into falling markets and buy when others are panicking. ______________________________________________________________________________ This week’s Trading Rules: If you’re going to panic, panic early. Retail investors often panic later, and for longer, than market professionals expect, creating larger crashes than fundamentals dictate. Match your investment time horizons to those of your investors. “Forever” is not a choice. The Fed hiked rates by 25 basis points for the first time in 7 years, and after initially popping higher, stocks have begun to fall again. Retail investors have seen most of the asset classes they flooded into in recent years decimated in the past 6 months. Large cap stocks have massively outperformed small caps over the past 6 months, with the Russell 2000 Index falling 12.7% versus a 4.9% decline in the S&P 500. This is inflicting pain on active fund managers and forcing performance chasing in the few winning stocks. Time ain’t no friend of these markets. SPY Trading Levels: Support: 200, 195, then 188/189. Resistance: 204.5/205, 209/210, 213 Positions: Long and short U.S. stocks and options, long CEFs, long SPY Puts.

The Deep Value Investing Philosophy During The Fed’s Ongoing War On Deflation

The definition of inflation is a general increase in the price levels for goods and services. Deflation is simply the opposite of inflation, where prices are declinin g, not rising. The Federal Reserve (Fed) is of the belief that targeting inflation at a rate of two percent is the optimal level for keeping the United States (U.S.) economy chugging along. Let’s compartmentalize for a moment whether the Fed is even measuring the true rate of inflation correctly. Taken from the Fed’s website , “Having at least a small level of inflation makes it less likely that the economy will experience harmful deflation if economic conditions weaken.” Former Federal Reserve Chairman Ben Bernanke had a religious devotion to the “inflation good, deflation bad” mentality as indicated by his academic work. Bernanke’s collection of research papers blame the Fed in the 1930s for not increasing the money supply to fight off deflation so as to avoid the Great Depression. Determined not to repeat the same mistake during the crisis in 2008, Bernanke aggressively implemented a quantitative easing program while simultaneously hammering interest rates to the floor. No monetary tool at the Fed remained idle in order to avoid deflation and the perceived risk that falling prices result in a collapsing economy. Looking at deflation from more of a bird’s eye view rather than simply looking at Bernanke’s favorite example of the 1930s Great Depression, a different conclusion might be reached regarding falling prices’ perceived linkage to a contracting economy. A previous study showed no connection between deflation and a depressed state in the overall economy. The study looked at more than 100 years of economic data spread out over 17 different countries. No correlation existed between deflation and a contracting economy across all international markets , including the U.S. Even when the microscope was put over the 1929-1934 deflationary period, half of the countries in the study experienced economic growth despite collapsing prices. There does not appear to be compelling evidence that the Fed adds value to the economy by targeting a particular inflation rate in order to avoid the scourge of deflation. As I mentioned in a previous blog , successful entrepreneurs focus on their own individual businesses. Monitoring macroeconomic variables as they do at the Fed is not a productive use of an entrepreneur’s time. Individual investors should have the same mentality when it comes to their portfolios. Rather than guessing the future rate of inflation and what effect it might have on financial assets, investors should focus on the minutiae of which stocks and bonds are of good value to purchase. Sliding the macroeconomic textbooks in a drawer and focusing on what stocks trade at a price point below some measure of intrinsic value is the behavior pattern of successful investors. One de minimis estimate of intrinsic value applied to a stock is its net current asset value calculation. The chart below shows the average annual return following the rigorous value investing criterion of purchasing only stocks trading below net current asset value. The performance results are independent of Fed policy and do not require an investor to have an opinion on the future rate of inflation. *Net Current Asset Value Portfolio has no more than a five percent weighting in any one stock. Dividends and transaction fees are included in all of the calculations. During years where few stocks could be found, funds remained idle in U.S. Treasury Bills. That subset of the Fed hierarchy who serve on the Federal Reserve Open Market Committee (FOMC) spend their days analyzing changes in various macroeconomic indicators, looking for clues as to the direction in which the overall economy might be headed. The FOMC is the primary decision-maker as to where short-term interest rates should be targeted. As already mentioned, its attempt at targeting the inflation rate is not consistent with statistical evidence in terms of stimulating the overall economy. Pushing interest rates to the floor in order to target a two percent inflation rate has resulted in retirees’ receiving little to no interest on their savings. This zero interest rate policy (ZIRP) has been in effect by the FOMC over the past 84 months. Unfortunately, an individual investor cannot control the behavior of the masterminds at the FOMC, but he or she can control what stocks to include in a portfolio. As indicated on the chart, embracing a deep value investing philosophy by purchasing only stocks trading below net current asset value outperforms the broad market average over the long term. This holds true both before and after the FOMC scrapes its targeted interest rate off of the floor. It is a peculiar financial world we currently live in. The FOMC pores over the changes in food, clothing, and energy prices purchased by consumers. These prices are manipulated by the Fed, forced to move in a direction that may be in conflict with where Mr. Market feels they should be headed. Over the past seven years, entrepreneurs in this country have been manipulated into misallocating resources via the forced feeding of ZIRP soup by the FOMC. Because of their low interest rate policy, the Fed’s mandate of seeking long-run employment and price stability has morphed into an orgy of enticing reckless speculation with regard to overpriced stocks. Getting paid to manipulate interest rates and blocking a clear view of honest price discovery in stocks seems to be a waste of taxpayer money and a major irritation to investors who embrace a strict value investing philosophy.