Dual Momentum: 6 Month or 12 Month Lookback

Dual Momentum, discovered and popularized by Gary Antonacci, is one of the investment strategies that I endorse and personally use.

Over time, Dual Momentum has performed extremely well compared with simple buy-and-hold, lazy style portfolios. It has also outperformed most complex investment strategies and most active managers of mutual funds.

The best part about Dual Momentum is its ease of management for any amateur investor. Dual Momentum hardly requires any work at all.

Once a month you evaluate three different investable asset classes, find the highest performing of those three asset classes over a specified historical time period, and invest your entire portfolio in that asset class.

These are very broad parameters, but are based on verifiable academic research. Dual Momentum is branded as such because it evaluates two simple forms of momentum: relative momentum and absolute momentum.

Relative momentum is the comparison of two assets within the same broad asset category. For the purposes of Dual Momentum, our relative momentum category is the equity universe: the U.S. stock index compared to the International stock index.

Relative momentum evaluations are not exclusive to broad stock indices. For example, if you compare the recent historical performance of Apple, Inc. (AAPL) and Microsoft (MSFT), you would also be conducting a relative momentum evaluation within the large-cap tech stock asset category.

Absolute momentum evaluations are the comparison of any asset class to a risk-free asset, usually represented by Treasury bills. In Dual Momentum, we compare our relative momentum evaluation winner to the recent historical performance of short-term government bonds.

Once you have determined the preferred asset after your relative momentum and absolute momentum evaluations, you would ensure your entire portfolio is invested in that preferred asset. If you already hold that asset (which is the case the majority of the time), you would do nothing that month. If you hold a different asset, you would sell the asset you have and purchase the asset dictated by your Dual Momentum evaluations.

Dual Momentum Variables

In Dual Momentum there are two main variables to consider that will impact your strategy in a meaningful way.

The first is choosing the lookback period you will use to determine your momentum evaluations. We'll cover a bit of that in this post.

The second is choosing the number and type of investment assets you will track. I have talked about that a bit in the past, but will do a new post in the future.

For the purposes of this post, we'll maintain the standard asset classes that Gary Antonacci has set out: U.S. stocks vs. International stocks, and the winner of that evaluation goes up against Treasury bills.

It's worth pointing out Antonacci introduces a small twist on the bond part. While he uses short-term government bonds (T-bills) when conducting his absolute momentum evaluation, he actually invests in the broad bond universe when the signal is in the risk-free asset. This small change increases overall returns over time.

Choosing Lookback Periods

One variable that is always up for debate with any momentum analysis is choosing the best lookback period to use when evaluating historical performance.

Gary Antonacci advocates a 12-month lookback period when sharing his strategy with the investing public. However, he also has made it clear he offers more responsive programs to institutional investors which purchase his services as a investment consultant.

Academic papers have evaluated lookback periods quite intensively. While the exact conclusion can depend on the asset being evaluated and the time frame used for the academic analysis, it is generally agreed that a lookback period between 3 months and 12 months can offer a momentum based advantage for investors. This is to say, assets which have outperformed in the past three to twelve months continue outperforming relative to other assets for some future time.

I don't disagree with Gary's public assertion to just go with 12 months because it is generally good. Something like choosing a time frame for performance evaluation can become a bit of a cherry picking exercise.

Maybe the ideal is 6.5 months for U.S. stocks between 1970 and 1996 and 11 months from 1996 until today. International stocks might be 10 months until 1988 when Emerging markets were added and just 5 months since that time. I don't know... but you get my drift here.

At the end of the day, you need to choose a standard metric that works generally well across all assets being evaluated.

Shorter Lookback Period

There are a few benefits to using a shorter lookback period. A short period will translate to a more responsive system. The signals are changing much quicker from month to month. This means you will have more trades.

At some point, the investor using short lookback periods will end up actually losing their performance advantage thanks to whip-saw trading. You are in one asset, get bounced out of that holding after a bad month, during the month you are out the first asset does very well compared to your new holding, and at the end of the month your evaluations put you back into the first asset again. If you would have simply held on, you would be better off.

For example, using a 6-month lookback since 1970, a simple Dual Momentum system would have counted a little over 100 trades. The largest drawdown would have occurred in the 1987 period with a -22.3% drop on a monthly calculated basis.

Longer Lookback Period

Using a longer lookback period, your system will be less responsive to changes in the market which occur in more recent months. The signals will change much slower, resulting in fewer trades.

This has pros and cons. Academic studies show that markets have mean reversion characteristics in short time-frames and over very long time periods.

Longer lookback periods can reduce disruption caused by short term mean reversions.

However, a drawback of a longer lookback period will occur when the market has a fast run up quickly followed by a steady fall down over a period of several months. You may be in a trade through the worst drawdown periods, only to get signaled out of the asset when it is recovering.

This was the case in 1987 where Dual Momentum would have moved you out of equities for a few months in the beginning of 1988, way to late to avoid the October/November Crash. By the time you were cycled out of equities in that fast crash, the market was in full recovery causing more portfolio damage.

If you use a 12-month lookback system since 1970, Dual Momentum would have counted fewer than sixty trades in 48 years. The largest drawdown on a monthly basis would have occurred in the 1973-1974 bear market with a loss just under 20%.

Time Averaged Dual Momentum - Combining Lookback Periods

For my own evaluation, I use both the 6-month and 12-month historical performance of each asset class by averaging the two period performances.

Using performance data since 1970, this strategy results in just four more trades being made over those 48 years when comparing to a simple 12-month lookback.

When comparing the combined lookback system's trades to the simple 12-month system's trades, the combined strategy is clearly more responsive. The combined system will move to a new asset class up to four months earlier than the 12-month system.

This small difference helps add nearly 0.5% per year in compounded annual returns.

The combined system also showed a smaller drawdown in nearly all drawdown situations over 10%.

Summary

When making a decision about lookback periods, I believe it is important not to overthink the process. You can do that by keeping your investing goals in mind.

By and large, a 12-month lookback period is fine. It gets you out of the market for those long painful bear markets, exactly like the kind we've experienced in 2000-2003 and 2007-2009 and will experience again at some point in the future.

It's easy to debate a half percentage here, or one percent there to find the "best" system out there. It all becomes largely irrelevant when the system is doing what it should: getting you out of a bear market at a 10% or 15% drawdown and helping you avoid the nasty 30% or 50% drawdowns that make serious dents in your financial situation.

The system I use is my Time Averaged Dual Momentum model--the system with a combined 6-month and 12-month lookback. Time Averaged Dual Momentum is easy to calculate, it is responsive, it has performed great over time, and there is no significant difference in the number of trades executed. Until the evidence demonstrates otherwise, I will predominantly share this system on the blog.

Dual Momentum based on longer lookback periods (combined or not) works well. It handily beats the S&P 500 over full market cycles, it beats passive buy-and-hold portfolios, it significant reduces drawdowns on your portfolio, it is very low cost, and it is an easy system to run in any self-directed portfolio.

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Converting Your RRSP to a RRIF

While most Canadians in the saving stage of their lives are happily contributing to and saving money on taxes with the RRSP (Registered Retirement Savings Plan), their older contemporaries are dreading the RRSPs close cousin, the RRIF (Registered Retirement Income Fund).

The RRSP is a fantastic savings plan that is nearly always the best account to prioritize when saving for retirement. When you contribute to your RRSP, you get to deduct the exact amount of your contribution from your annual income at tax time. This means you are effectively contributing to your RRSP with "before-tax" money. Contributing with before-tax money helps you maximize your savings and minimize your tax bill.

However, the RRSP has a few catches. Withdrawals from your RRSP are fully taxable as regular income. Also, you are subject to tax withholding on RRSP withdrawals. For example, if you want to withdraw $20,000 from your RRSP, the bank will withdraw an extra $8,571 and send that money straight to the Feds for a total withdrawal of $28,571.

When you do your income tax filing, months later, that $8,571 will show as taxes already paid. Your total RRSP withdrawal (taxable income) will show as $28,571. Then, if the bank withheld too much money from your RRSP as part of the mandatory tax withholding, you get a tax refund bank for that same amount. If you should owe no tax at all based on your income and deductions, the CRA will send the entire $8,571 back to you.

This hefty tax withholding is not an accident. While the government wants you to save in your RRSP, they also want to discourage you from withdrawing money from your RRSP until you are retired. While the benefits of discouraging early RRSP withdrawals probably outweigh the costs overall, it is certainly inconvenient for a high saver, early retiree.

The account the government wants you to withdraw from is the close cousin of the RRSP--the RRIF.

An Overview of RRIFs

The RRIF is the withdrawal-only version of the RRSP. You cannot contribute to a RRIF and you must make minimum withdrawals every year based on your account valuation and age on December 31 of the previous year. It is important to note that you can use the age of the younger spouse when calculating your RRIF factor minimum withdrawal.

In your RRIF, you may invest the money in the exact same instruments as a RRSP. This also includes holding your own non arms length mortgage. When moving money from your RRSP to your RRIF, you should be able to transfer those investments over "in-kind". Also, the transfer and any asset sales within your RRSP or RRIF account are not considered taxable events.

To calculate the minimum amount of your withdrawal, use your age on December 31 of last year, find your RRIF factor, and multiply that by your RRIF account value on December 31 of last year. For example, if my 65th birthday is in February of the current year and my RRIF account valuation on December 31 of last year was $300,000, my minimum withdrawal for this year is $11,539 ($300,000 * 3.8462%). I must withdraw at least $11,539 sometime between January and the end of December of the current year.

This is the minimum withdrawal factor table from age 50:

Source: TheRichMoose

Every RRSP account must be converted to a RRIF account in the year that the account holder turns 71. However, anyone holding an RRSP account may convert a part, or all, of their RRSPs to a RRIF at any age.

Benefits of Withdrawing from a RRIF

There are a few reasons why someone under the age of 71 would voluntarily want to convert their RRSP to a RRIF. Even in these circumstances, I believe it is generally best to convert just part of your RRSP to a RRIF to take advantage of the benefits. Leave an active RRSP account in place so you have the option of contributing and getting tax breaks should your circumstances change.

1. Take advantage of pension income tax credit

If you are 65 or older, you are eligible to claim the pension income tax credit for certain forms of income. Pension income includes RRIF withdrawals, but does not include standard RRSP withdrawals.

The pension income tax credit will give you a $2,000 deduction at tax time, helping you save hundreds of dollars a year in tax. The exact amount will depend on your income and province of residence.

If this is your goal, you should be careful only to transfer enough money to your RRIF from your RRSP to take advantage of this credit.

2. Splitting income with your spouse

If you are over the age of 65, and you are eligible for the pension income tax credit, you can also split up to 50% of your qualified pension income (includes RRIF withdrawals) with your spouse. Splitting income with a spouse is a huge tax benefit that can cut your tax bill in half.

For example, if you spend $50,000 per year in Ontario, you would have to withdraw $56,500 as an individual, but that drops to just $53,200 if it is evenly split with your spouse. Never say "No" to saving an easy $3,300 per year on taxes alone.

If you have a large RRSP, but your spouse does not, then moving a substantial portion of your RRSP to a RRIF at age 65 could be well worth your while just to take advantage of income splitting and saving money on tax.

3. Save money on withdrawal fees

Most brokerages will charge a higher fee for RRSP withdrawals than they do for RRIF withdrawals. This is because RRSP withdrawals are considered a partial de-registration. The brokerage fee for a RRSP withdrawal will probably be in the range of $50. A withdrawal from a RRIF can be anywhere from free to $50 at most brokerages.

If you are only doing one withdrawal per year, which I recommend if you are doing a RRSP withdrawal for the tax free RRSP withdrawal plan, switching to a RRIF to save fees probably isn't worthwhile. But, if you are looking for steady monthly income by way of registered plan withdrawals, it is almost certainly better to move at least a good portion of your RRSP to a RRIF.

4. Avoiding income tax withholding

When you withdraw money from a RRSP account, the brokerage is obligated to withhold anywhere from 10% to 30% of the value of the withdrawal and remit that to the CRA as an advance on your income tax bill for the year. However, up to the minimum withdrawal amount based on your RRIF factor, your brokerage will not withhold any money for taxes on RRIF withdrawals.

If you know you are withdrawing a certain amount of money from your RRIF every year, it may be worthwhile to convert some of your RRSP to a RRIF. I should point out that the argument here is weak because you will get any excess taxes withheld from you refunded back in March or April when you do your taxes.

The income tax withheld on RRSP withdrawals is not a separate tax from income tax itself, it is simply an advance to the CRA to discourage you from making withdrawals from your RRSP, and ensure the government gets paid their due. It is no different from your employer withholding tax from your paycheque or the CRA requiring you to make installment tax payments throughout the year if you are self-employed.

Summary

In general, I believe it can be advantageous from a tax savings and fee savings perspective to convert part of your RRSP to a RRIF when you turn 65 and are otherwise eligible for the pension income tax credit. Be hesitant to convert your entire RRSP over to a RRIF before the age of 71. Doing so will limit your options to contribute to a tax advantaged account and reduces withdrawal flexibility.

You can move money from your RRSP to a RRIF in chunks every year, so it is often worth your while to do some math and find an optimal RRIF balance to maintain for your personal situation. When in doubt, err on the side of caution and keep your RRIF a bit smaller than your calculations would suggest the maximum amount should be.

You are not required to open your RRIF at the same brokerage where your current RRSP is held. Examine your options and look at the fees for each brokerage. While some online self-directed brokerages charge annual fees and withdrawal fees for RRIF account, others do not. Look for low cost options and save yourself hundreds of dollars in fees each year.

Once you have opened a RRIF, think about your overall withdrawal plan and your investment situation. To keep your finances easy to manage, it may be a good time to open a high interest savings account. Consider making withdrawals from your RRIF just once or twice each year and depositing that money in the savings account.

Make your minimum withdrawal amount based on your RRIF factor at the beginning of each year as no tax withholding is kept from this withdrawal. Make any additional withdrawals near the end of the year to reduce the amount of time the CRA is holding onto your money. Don't forget you may be realizing taxable income from other sources (dividends or interest from non-registered investment accounts, rental properties, CPP/OAS, etc.) throughout the year.

Comments & Questions

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