Dual Momentum: Easy Trend Investing

One form of trend investing I really love for many reasons is Dual Momentum Investing.

Dual Momentum Investing has shown great results, it is easy to administer, it is pervasive across many market conditions, and it really reduces the kind of portfolio volatility that makes many investors do stupid, stupid things.

It might be the near-perfect solution to many self-directed investor problems—particularly human psychology.

Dual Momentum Background

The Dual Momentum strategy was brought to the public by Canadian money manager Gary Antonacci. He wrote a detailed white paper on the strategy a few years back and then published a book on the strategy as well.

Gary's Optimal Momentum website explains the strategy in good detail and his white papers are posted for your reading pleasure on SSRN.

The great thing about Gary is that he freely shares this strategy which is simple and has handily outperformed the broader stock market over whole market cycles (top-to-top or bottom-to-bottom).

Hearing several podcasts featuring Gary and reading his blog faithfully, I genuinely get the impression that Gary is an all-around good guy who shares this great information because he cares to make the investment returns of amateur self-directed investors better.

Gary is also super blunt. When criticized by many over the pervasiveness of the strategy over other investment approaches like buy-and-hold, his answer is simple: I'll be the first to tell everyone to ditch the strategy when it actually underperforms a whole market cycle.

Dual Momentum Results

Based on Gary's data—which is done in U.S. dollar investing—the Dual Momentum strategy has returned over 17% compounded annually since 1974. That beat the MSCI World IMI Index by approximately 9% per year over 4 decades!

Putting that into real money perspective, if you follow my minimum savings rules and put away $562 a month for 35 years, a regular buy-and-hold strategy would net you about $800,000 in today's dollars at 6% net return.

With Dual Momentum, if historical returns stay the same, you would have $8.2 million. That's a whopping 10x difference: the real power of compounding interest!

Even more appealing to me is this strategy has not had a draw-down of more than 20% since 1974. To get a comparable max draw-down with buy-and-hold investing, your portfolio would have consisted of more than 60% bonds. That would have left just 40% for the higher growth stock allocation. Your gross returns on a portfolio with similar risk would have been 7% per year (4.5% after inflation).

A lot of investors can tolerate a 20% loss without too much panic. Sure losing $100,000 on a $500,000 portfolio stings, but you can probably carry on with your plan.

Losing half your portfolio is what makes people go squirrelly, panic, dump everything into GICs, and moan and bitch to everyone who lends them an ear about the dangers of stocks and why their house is a so much better "investment".

Basics of Dual Momentum

Dual Momentum Investing is based on considering two factors: relative momentum and absolute momentum. Dual Momentum (GEM) strategy evaluates just three asset classes: U.S. stocks, international stocks, and cash using three different ETFs.

Basically you consider momentum factors and then invest 100% of your portfolio in the asset which has performed the best over a specified period of time.

Historically the invested asset class has changed just over once per year. This means minimal trading costs and little stress about picking the right day to evaluate. It really doesn't matter whether you are religious about checking in on your portfolio the first trading day of each month, or if you let it slip a few days every now and then.

For Canadians, I would suggest the best options for evaluation today are: XUU.TO for U.S. stocks, XEF.TO for international stocks, and XSB.TO for short-term bonds.

Once a month we evaluate our options and choose the best performing ETF for our portfolio holding. It's extremely simple and very effective.

For those who are okay doing something just a bit different but don't want to be a dedicated trader, Dual Momentum Investing may be the best long-term sustainable choice.

Evaluating Relative Momentum

Relative Momentum means comparing the historical performance of an asset with others in its broader asset class over a specified time period.

While opinion differs on the timeline that should be used, I personally like looking at the past 12 month performance and the past 6 month performance and averaging the two.

This is where we evaluate the total return performance of the two broad stock asset classes: XUU.TO and XEF.TO.

Here is the comparison on July 31, 2017:

XUU.TO 6 month: +4.13%
XUU.TO 12 month: +11.11%
XUU.TO Average: +7.62%

XEF.TO 6 month: +9.54%
XEF.TO 12 month: +13.22%
XEF.TO Average: +11.38%

By this relative momentum evaluation, XEF.TO is the clear winner. Therefore XEF.TO is our choice for the stock asset class.

However, we are not done here. Now we need to evaluate the performance for the absolute momentum side.

Evaluating Absolute Momentum

Absolute Momentum is the evaluation of an investable asset's performance compared to cash (T-bills) over a specified time period. Again, I like averaging the 12 month and 6 month performance.

T-bills (very short-term government bonds) are used here because they are widely perceived to be a nearly risk-free asset class. A short-term bond index ETF (such as VSB.TO or XSB.TO), does a decent job of substituting for T-bills in this evaluation.

Some other writers, including Antonacci himself, compare to T-bills but choose a broad bond index for their investment choice. To me, using a short-term bond index ETF for our comparison and investment choice is easier and just as effective.

Here is the comparison as of July 31, 2017:

XEF.TO 6 month: +9.54%
XEF.TO 12 month: +13.22%
XEF.TO Average: +11.38%

VSB.TO 6 month: -0.31%
VSB.TO 12 month: -0.59%
VSB.TO Average: -0.45%

In this absolute momentum evaluation, XEF.TO is again the clear winner.

So, currently you would have 100% of your portfolio invested in just one ETF: XEF.TO. This gives you an indirect stake in 2,500 companies located across Europe, Australia, and Japan.

I will be publishing the Dual Momentum recommended signal based on this evaluation every month in the Portfolio Update posts. I think it would be a great strategy to keep an eye on.

Comments & Questions

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Simple Trading is Good Trading

I love things to be quite simple and straightforward. If I can understand a concept or strategy, and if I can explain that strategy to a teenager in a few hours time, I'm okay using it. I can trust it.

To me, investing is a lot like life: complexity doesn't make things better and you're likely to f*ck it up and be worse off than when you started.

Trading—in the context of trend investing—often has very negative connotations of being either completely kooky or overly complex. The terms technical traders use don't help: cup and handle, head and shoulders, resistance points, wedges, triple tops, triple bottoms, dead cat bounce, and so on.

Naturally these traders are poor advocates for the concept of trend investing, or trend trading. Nothing turns off an investor interested in these strategies more than seeing a chart like the one below. It's confusing and simply ridiculous.

Edited Photo. Source: FreeStockCharts.com

The truth is these overly technical traders tend not to do so well investing. They often trade short cycles, look for too many indicators, and get jumpy looking for reasons and indicators to explain each move. Many technical traders incur high trading costs and have a low overall success rate.

A study put out by Fidelity out of the U.S. showed that the account holders who performed the best were dead, or forgot about their accounts. While certainly not conclusive, this can imply active investing is a fool's sport.

Well, I am ready to be a fool because I believe the majority of these poor returns were the result of bad reactive trading. Selling stocks after a market crash and pouring money into GICs. Buying stocks when things are already way too hot. And trading based on "tips" or financial news.

The real problem in the majority of these cases was the lack of a plan, or lack of investing discipline.

Simple Trading Is Risk-Averse Trading

Trading does not have to be complicated. The basic premise of trading is following a set of rules that guide you on when you should enter a position and when you must exit a position. The exit is the most important part!

Trading done right it is likely to limit losses on downturns. This helps reduce portfolio volatility. It also opens up the possibility of beating the market over the long haul because the market downturns don't take as much wind out of your sails.

If a stock or market is trending up, it's very likely to keep climbing in the medium term. Likewise, if a stock or market is moving lower, the path of least resistance is that it goes still lower. This attribute of trend (or momentum) is very well researched.

This reality counters what most traders believe as demonstrated by their actions—particularly with nervous fundamental investors. Many investors will sell their position as a stock is climbing, mainly because they want to take the gain and are afraid of seeing a rising stock fall. Often they'll actually see the stock they sold continue to move higher and higher.

Likewise, many investors "double down" on a position that's in a loss. They don't want to sell at a loss, believe the stock will go back up, and buy additional shares to bring down their cost average. They might also believe their personal analysis of the stock values it higher than the current price. Unfortunately, more often than not the stock will continue to slide lower and lower.

When this is pervasive, it isn't just a case of bad luck or a wrong call: it's human nature. We're adverse to loss and it costs us big time. We also tend to lack self-discipline when not having broad rules to govern our behaviour.

Using Moving Averages

There are only a few rules which I use and I shared them in my intro to trading post. It all boils down to two simple factors: trade based on moving averages (or breakouts) and always look to limit risk.

On pretty much every brokerage website, or even Yahoo!Finance, you can run Simple Moving Averages (SMA) and Exponential Moving Averages (EMA). I like to use both, and I prefer using medium to long term averages. Moving averages help smooth out prices so you can get a clearer picture of what's happening.

I also find it useful to run two separate ranges to help scale into a position. For example, I might enter a position with say 10% of my portfolio value when the price crosses the 100-day SMA to probe the trend. Then, if the price crosses the 200-day SMA, I'll top it up with another 10% to make the position a full 20% of my portfolio.

I typically do not buy unless the price has fallen below all the moving averages, showing a clear correction and re-entry point. Using moving averages to identify bounces can ensure better grasp of the price trend.

For example, a price might just touch a moving average line triggering a sell signal. If it immediately moves up the next trading day, it may be worthwhile to re-enter the position quickly at a small cost. It's an unfortunate cost of trading, but hopefully the price of re-entry is little more than the commissions.

On the sell side, I will absolutely sell if my initial position (or probe) falls after purchase between 5-10%. I know the trend is not in my favour, so I want to limit my loss. I'll also sell once the price falls below the long-term moving average I'm using.

Example using XIC.TO, the iShares TSX Capped Composite Index ETF:

Source: TheRichMoose.com, Questrade.com

I've run a 100-day SMA, 100-day EMA, and 200-day SMA over the past three years. Let's review my potential actions:

  1. Enter a 10% position in November 2014 at a price of ~$23.50 when it crossed the 100-day EMA;
  2. Sell the position a few weeks later at ~$23.85 when price fell below the 100-day SMA (profit 1.5% in less than a month);
  3. Enter a 10% position in the beginning of January 2015 at ~$23.25 when price crossed above the 100-day EMA;
  4. Add another 10%  to have a full position at the end of January 2015 at ~$23.50 when the price crossed over the 200-day SMA;
  5. Sell in March 2015 at ~$23.60 when the price fell below the 200-day SMA (profit 1.5% on first 10% and 0.4% on balance);
  6. Enter a 10% position in March 2016 at ~$20.70 when price crosses 100-day EMA;
  7. Add another 10% to the position in April 2016 at ~$21.40 when price crosses over 200-day SMA;
  8. Sell in May 2017 at ~$24.70 when price fell below 100-day SMA (profit 19.2% on first position and 15.3% on balance)

Some of the trades didn't make a whole lot of money, but every trade was profitable and that matters. While the overall ETF price was basically flat over the past 3 years, this simple strategy made more than 15% and provided the opportunity to earn even more during the out periods. Also, you would never have seen a drawdown of more than 5%.

Some would scoff at making these 8 trades over the 3 years—preferring the simplicity of buy-and-hold. That's fine, but recognize it's a completely different type of investing.

Trading means paying more attention to your portfolio, setting up stop loss orders, watching several potentials for entry points, and completely blocking emotions or stupid temptations. It's not for everyone. In fact, I would say it's not ideal for most people who have better things to do than track ETFs and stocks.

Comments & Questions

All comments are moderated before being posted for public viewing. Please don't send in multiple comments if yours doesn't appear right away. It can take up to 24 hours before comments are posted.

Comments containing links or "trolling" will not be posted. Comments with profane language or those which reveal personal information will be edited by moderator.