How Does Dual Momentum Perform with Leverage

Dual Momentum is a great way for a self-directed investor to take advantage of a simple investment method which has provided higher than index historical returns with lower drawdowns.

My Time Averaged Dual Momentum model uses an average of the 6 month past performance and 12 month past performance in the Dual Momentum analysis. The 48 year backtest shows annual returns averaging more than 16% per year with a max drawdown of 22.47%.

I detail my Time Averaged Dual Momentum model analysis on the Portfolios page of this blog. The page also includes a backtest showing simulated historical results going back to 1970 comparing my Time Averaged Dual Momentum to an equal weight buy-and-hold strategy (66% equities with 33% bonds) over the past 48+ years.

Dual Momentum—as popularized by Gary Antonacci—evaluates three main asset classes. The two equity assets are U.S. stocks compared with International stocks in a relative momentum test.

Following this, the best performing equity asset is compared to the risk-free rate of return—represented by Treasury bills—in an absolute momentum test. The best performing asset is the investor's sole holding for the next month.

Pros and Cons of Leverage

Understanding Problems with Leverage

From what I've gathered reading Gary Antonacci's work, he has typically frowned on the idea of adding leverage to the Dual Momentum model.

His response goes something like this: Dual Momentum still has a lot of short-term volatility, leveraged products (like ETFs) have their own issues which make them less efficient than you think, and the consequent drawdowns of added leverage are likely to be too high for many people.

I don't disagree with most of Gary's perspective. Dual Momentum is designed to be a less risky investment strategy that is easy to follow. Low relative drawdowns means more "stick-with-it-ness" for the average investor.

The value of sticking to a good investment strategy should not be underestimated. Both self-directed investors and professional advisors are notorious for their poor long-term performance purely due to strategy changes and fund turnover.

According to Dalbar studies, the average investor is better off investing 100% of their portfolio in intermediate duration Treasury bonds than trying to invest on their own with various equity strategies.

Aggressive strategies will typically fail in the long run for most investors. Not because the strategy itself failed, but rather because the human executing the strategy failed to keep their emotions in check.

Benefits of Leverage

All this said, I am still a big proponent of proper use of leverage in self-directed investor portfolios. For the smaller group of investors out there who are seeking high overall returns, leverage is the only consistent option.

Other promoted high return strategies are often timing period based, temporary, or inconsistent. Winning stock picking strategies come and go, isolated sector bulls come and go. Even factor-based advantages are not always a great choice.

Proper, risk-adjusted use of leverage is a consistent way of gaining an advantage on the broader markets. This includes use of leveraged ETFs when paired appropriately with safer assets like Treasury bonds, or even short-term high-grade corporate bonds.

Adding Leverage to Dual Momentum

There are two main methods an investor can use to employ leverage with their Dual Momentum strategy.

Using margin to buy standard ETFs is often the better choice in non-registered investment accounts. This eliminates tracking error issues and provides access to a broad range of high volume ETFs.

You can generally deduct the interest expenses on your tax return when you borrow money used to purchase an investment in a non-registered account.

Also, your margin loan interest rates in a good non-registered account are likely to be very competitive at brokerages like Interactive Brokers.

Leveraged ETFs are typically the better choice for accessing leverage in registered accounts. When you borrow in a registered account, you are likely going to pay extremely high interest rates to your broker. In addition, you will not be able to deduct those interest costs from your income on your tax return.

On the U.S. stock exchanges, there are several options for leveraged ETFs for each asset class. Thanks to their growing popularity, there are a number of very high volume ETFs with thin trading spreads.

In my evaluations for adding leverage, I did a monthly readjustment on the leverage. This will vary somewhat from real-world results if you use a daily leveraged ETF, or if you leverage up manually with use of margin. However, the results should be fairly close to both of these methods.

I only applied leverage to the portfolio with the TADM signal was in equity holdings. When the signal is in the bond allocation it rarely makes sense to use leverage as the return differential is not as large.

Adding 1.25x Leverage

I performed three separate leverage tests. This first test was leveraged 1.25x, or adding 25% exposure to the base allocation.

I chose this leverage factor as it is available in the market in ETF format thanks to the Portfolio+ ETFs which are listed on the U.S. exchange. Trading volume is still light in these products, but should be satisfactory for a smaller self-directed investor.

The Portfolio+ products have a current expense ratio of approximately 0.4%. I adjusted the returns down on a monthly basis for each month the portfolio was in equities to reflect the increased cost of this leveraged product compared to standard ETFs.

Source: TheRichMoose.com

TADM with 25% Added Equity Leverage Statistics

Compounded Annual Return:  +19.19% (48 years)
Largest Annual Gain:  +91.66% (1986)
Largest Annual Drawdown:  -12.31% (1973)
Peak to Trough Drawdown:  -29.97% (1973-1975)

Adding 1.5x Leverage

The next leverage test I performed was increasing the equity exposure by 50% on a monthly adjusted basis.

This level of leverage exposure on equities is not currently available in ETF format. If you want to follow a 150% exposure model in a registered account, I would recommend using 2x leveraged ETFs with 75% of your account and leave the remaining account in cash or short-term bonds.

The cost of a 2x leveraged ETF is approximately 0.9%, an increase of about 0.8% over standard ETF products. I adjusted the returns down on a monthly basis for each month the portfolio was in equities to reflect the increased cost of using leverage.

Source: TheRichMoose.com

TADM with 50% Added Equity Leverage Statistics

Compounded Annual Return:  +22.01% (48 years)
Largest Annual Gain:  +115.00% (1986)
Largest Annual Drawdown:  -16.13% (1973)
Peak to Trough Drawdown:  -37.09% (1973-1975)

Adding 2x Leverage

The next leverage test I performed was increasing the equity exposure by 100% on a monthly adjusted basis, effectively doubling the exposure for each signal change.

There are a number of ETFs on the market with 2x leverage on a daily adjusted basis. Even the Canadian exchanges have 2x leveraged products provided by Horizons ETF.

It is also easy to double your exposure with margin loans in a non-registered account. Most margin loans will require 33% equity on the loan. This means a 2x exposure is about as high as you want to go with adequate safety to prevent margin calls.

The cost of a 2x leveraged ETF is approximately 0.9%, an increase of about 0.8% over standard ETF products. I adjusted the returns down on a monthly basis for each month the portfolio was in equities to reflect the increased cost of using leverage.

Source: TheRichMoose.com

TADM with 100% Added Equity Leverage Statistics

Compounded Annual Return:  +28.45% (48 years)
Largest Annual Gain:  +170.41% (1986)
Largest Annual Drawdown:  -23.36% (1973)
Peak to Trough Drawdown:  -49.17% (1973-1975)

Summary

My Time Averaged Dual Momentum model would have performed extremely well when adding leverage to increase the holdings when the signal is in U.S. or International stocks.

The results are simply outstanding, increasing up to a compounded annual return of nearly 30% per year for 48 years at a 2x leveraged equity level. That is a better result than Warren Buffett, John Templeton, and Peter Lynch achieved.

To put that result into some perspective, if you have $100,000 today and you invest in the 2x leveraged model for the next 30 years without any deviation, your portfolio would grow to approximately $183,000,000. (Provided, of course, that future returns are similar to past returns and the costs of leverage stay similar to what they are today.)

However, with increased leverage, Dual Momentum ceases to be a fantastic investment approach for risk-averse individuals. Once you take on a strategy with expected 50% drawdowns, would you be able to stick with the strategy when those drawdowns go to say 60% or higher?

Remember, when you have a model that is historically backtested over an adequate time period, you still need to expect your extreme results to be 25% worse in the future.

Personally I like the 1.25x model for an investor who is looking to add a bit of an edge to their Dual Momentum portfolio. With just 25% leverage, the daily re-balanced ETFs still track very well to the index over long holding periods.

Adding 25% with a margin loan is also very feasible, low risk, and low cost. There is almost no chance of a margin call, plus this leverage amount is easy to maintain on a monthly basis. The leverage is unlikely to run away from you from the time you enter a new position to the time the signal changes to a new position.

Of course a 19+% return compounded over 30 years should not be minimized. That would grow a $100,000 portfolio today into more than $19.3 million dollars. Alternatively, investing $500 a month for 30 years would grow to $9.57 million.

The volatility at 25% leverage is still amazing at less than 20%! Historical drawdowns are under 30%, annual losses of less than 15%, and annual gains up to 91%!

Although a somewhat imperfect measure as the extreme results are tilted to the upside in Dual Momentum, a 25% leveraged TADM model has an impressive Sharpe Ratio of 0.863.

Comments & Questions

This is an archived post and all comments are disabled for management efficiency. You can email me for direct questions.

Please visit my new website and blog for current posts on financial topics. DArends.com

Testing Dual Momentum in Japan

Any investment strategy you contemplate should be stress-tested for performance in bad times as well as good times. One of the best, true scenario, ongoing investor stress tests is still occurring in Japan right now.

Japan is the market that no buy-and-hold investor wants to talk about. It has been a true nightmare scenario. The average Japanese equity investor is hardly better off now than they were in 1990. A stock/bond portfolio would have experienced pitiful returns, even after factoring in currency strength.

In the past 30 years, Japanese investors have gone through two massive bear markets. One jaw dropping ~70% decline took more than a decade to hit bottom (1990 to 2003). Then, just as things started to look up, investors were hit by another ~60% crash from 2007 to 2009.

So naturally I had to see what would happen if a Japanese investor was using a local version of the Dual Momentum strategy.

Background of Japan's Economy

The Japanese nearly lost their entire economic base as a result of World War 2. Thanks to U.S. financial backing, a hard-working population, and a culture of perfection, Japan's economy quickly began to boom. By the 1980s, Japan developed into a global export powerhouse and first-world economy.

From the 1950s on, Japan's economy grew at annual rates of 8% or higher for several decades. The Japanese developed unmatched technical expertise in certain industries. The western world—still young enough to remember World War II—feared Japan may take over the U.S. as the global financial and economic centre.

After export growth slowed, domestic consumption skyrocketed in the 1980s. Property prices got so expensive in the late 1980s that the land in Japan was worth more than the entire United States. As you could imagine, much of this was propped up by massive loan growth. (Sound familiar?)

However, Japanese assets reached their peak valuations in the beginning of 1990. Since then real estate prices have dropped to a fraction of their former value. Bond yields have dropped to nothing as the government tried to stimulate the economy with negative interest rates. The stock market collapsed, led by big financial corporations and companies with high real estate holdings.

Despite the economic turmoil, Japan still has a powerful economy with many large corporations. The Japanese stock market is the second most diverse investable market in the world, following the U.S. markets.

Japan's currency, the yen, is a popular reserve currency which competes with the Euro and British pound for prominence behind the U.S. dollar. The Japanese yen has actually strengthened in value compared to other major currencies since 1990, including the U.S. dollar.

The Power of Dual Momentum

Dual Momentum is a simple timing strategy that can be used by any investor to reduce risks and achieve better investment performance. I talk about Dual Momentum in detail in the model portfolio page.

In a Dual Momentum evaluation, an investor assesses the past 12-month performance of three broad assets at the end of each month. After calculating the performance for each asset, the investor performs a momentum evaluation to determine the Dual Momentum signal for the following month.

First, the investor performs a relative momentum evaluation, comparing the performance for the two equity assets. Once the best performing equity asset has been identified, the investor performs a second absolute momentum evaluation comparing the preferred equity asset to the risk-free rate of return.

If the selected equity asset has outperformed the risk-free asset, the investor invests their entire portfolio in the lowest cost version of that equity asset. If the risk-free asset outperforms, the investor puts their entire portfolio into bonds.

For this Japanese Dual Momentum test, I used the following asset data. All assets include distributions (gross returns) and are priced in Japanese yen.

Equity Assets

  • MSCI Japan Index (1970-2017)
  • MSCI Kokusai Index (1970-1987), replaced by the MSCI ACWI ex Japan (1988-2017)

Risk-Free Asset

  • Japan Treasury Bills (1970-1979), replaced by Japanese 3 Month CD (1979-2017)

All of these assets were priced in the local currency (Japanese yen). Remember, the point of the backtest is to see the theoretical results of a Japan-based investor, not a U.S. or Canadian investor using these indices.

Japanese Dual Momentum vs. Buy & Hold

Dual Momentum (Japan) Results

This test is a full return profile for Dual Momentum since 1970—the earliest point where global broad stock data has become available. In the earliest points of this graph, Japan's economy could still be considered a developing market with the higher volatility that is characteristic of less developed markets.

The returns that Dual Momentum would have generated for a Japanese investor are nothing short of phenomenal. Japan was a true wealth building economy!

But as you can see, buy-and-hold would have worked fantastically as well. Until 1990 that is...

Source: TheRichMoose.com, MSCI, FRED

Dual Momentum would have provided the following results for Japanese investors.

Compound Annual Return:  +10.46% (49 years)
Largest Annual Gain:  +117.05% (1972)
Largest Annual Drawdown:  -21.18% (1973)
Peak to Trough Drawdown:  -29.96% (1987)

In comparison, the MSCI Japan index (in yen) returned the following results.

Compound Annual Return:  +6.28% (49 years)
Largest Annual Gain:  +117.05% (1972)
Largest Annual Drawdown:  -42.48% (2008)
Peak to Trough Drawdown:  -67.62% (1990-2003)

After the Bubble (Post 1989)

Of course it is pointless to test the robustness of Dual Momentum if we don't take a closer look at the past three decades where Japanese investors suffered from a massive correction.

As the graph shows, Dual Momentum really shines in turbulent times. While a buy-and-hold investor would have lost money, the momentum investor would have increased their wealth 10x in the same time period.

Source: TheRichMoose.com, MSCI.com, FRED

Since the end of 1989, the peak of the Japanese bubble, Dual Momentum provided the following results for Japanese investors.

Compound Annual Return:  +7.47% (29 years)
Largest Annual Gain:  +54.80% (2013)
Largest Annual Drawdown:  -13.67% (2000)
Peak to Trough Drawdown:  -22.92% (2015-2016)

In comparison, the MSCI Japan index (in yen) returned the following results after the bubble.

Compound Annual Return:  -0.76% (29 years)
Largest Annual Gain:  +54.80% (2013)
Largest Annual Drawdown:  -42.48% (2008)
Peak to Trough Drawdown:  -67.62% (1990-2003)

Summary

The Japanese case study provides an interesting insight into how Dual Momentum works across a broad range of market conditions. Dual Momentum is a robust investment strategy that performs well, even when the local markets experience big setbacks.

During the Japanese bull market preceding 1990, the momentum investor would have actually lagged the buy-and-hold investor by a small margin. An all-equity buy-and-hold investor would have grown their portfolio at an astounding compound return of 17.34% per year.

After the crisis began to unfold, Dual Momentum began to show its true strength. A compound return of 7.47% per year is an extremely good result over a three decade period, especially compared to a negative annual return for a buy-and-hold investor.

Comments & Questions

This is an archived post and all comments are disabled for management efficiency. You can email me for direct questions.

Please visit my new website and blog for current posts on financial topics. DArends.com