A Better Look at Dual Momentum Fragility

Several weeks ago Corey Hoffstein of Newfound Research raised some important questions about the fragility of 12-month Dual Momentum (GEM) shared by Gary Antonacci. Gary responded in kind and it sparked a debate about 12M Dual Momentum and some related issues.

One of Corey's main arguments is that Dual Momentum, when measured only with a 12M lookback period, carries inherent and avoidable fragility. He notes that the model results vary meaningfully just by changing a single metric such as the number of months in the lookback period.

Corey suggests that investors can reduce risk by effectively tranching their Dual Momentum portfolio into multiple portfolios (he tests a model with 7 tranches) where each tranche invests in Dual Momentum following a different lookback period (6M through 12M). The tranches would be re-balanced each month to ensure equal impact of each lookback period.

This then led the debate to the next stage: setting aside Dual Momentum's recent signals, is there some reason to believe that the 12M lookback period is better than other periods (8M, 11M, etc.) to the extent that we should use it exclusively?

Is a 12-Month Lookback Better?

Gary argues essentially that 12M is better. It shows the best overall performance results for stocks, and this seems to be confirmed by academic evaluations going back a century or more. However, despite all the research, could this outperformance be a fluke?

I encourage you to read Gary's post which I linked above to understand some of the academic support behind the 12M lookback. This idea warrants a logical evaluation, especially how it relates to a self-directed investor implementing a Dual Momentum strategy for their retirement savings.

For the purposes of this argument, I will focus on the longer term lookback periods: 6M to 12M. While the shorter periods may have their own merits, they do require a lot more trading activity which I believe many self-directed investors would prefer to avoid.

First, although the 12M period does look really effective across the stock universe, I think it is somewhat speculative to say that 12M is the best. Lets look at some measures to test this.


Sources: TheRichMoose.com, MSCI Inc., FRED

Looking at the drawdowns since 1970, it is hard to say that one lookback period is better or safer than the other. The 12M model has the largest absolute drawdown; however, the 6M spends more time in drawdown and comes very close the 12M model's biggest drawdown.

Both models share quite similar drawdown characteristics. They are highly correlated with the periods in drawdown showing significant overlap. When the 6M is in a drawdown, the 12M is also in a drawdown 86 percent of the time. Likewise, when the 12M is in drawdown, the 6M is also in drawdown 90 percent of the time.

However, although strongly correlated, they are certainly not precisely aligned. If I had to lend a preference to a lookback period based on drawdowns only, I would probably give a slight edge to 6M.


Sources: TheRichMoose.com, MSCI Inc., FRED

Looking at returns since 1970, we see the 12M system doing better overall. However, this is primarily due to lackluster performance in the 6M system in the late-1980s into the mid-1990s. Prior to, and following this period, 6M ran very close to 12M on an annualized rolling return basis.

Sources: TheRichMoose.com, MSCI Inc., FRED

Looking at the annualized 5-year rolling returns of each lookback period tested, we can clearly see the drop in the 1980s and 1990s for the 6M system. However, the chart also shows the systems performing quite comparably in the other market periods.

In fact, the two systems are 87.78 percent correlated on a monthly return basis over the period of 1970 through 2018. Despite the differences in end return, the monthly returns are very similar.

I think it is reasonable to assume that there may be some point in the future where 12M will underperform 6M by a reasonable margin for some time. After all, we do have limited data to work with and the returns observed for each system are within the historical ranges for the other system.

Sharpe Ratios

The Sharpe ratio is a common measure of portfolio performance factoring in risk. In this measurement, risk is measured via standard deviation which has its drawbacks—particularly when Dual Momentum has downside guards in place.

By this I mean, standard deviation measures return variance to the upside and downside as equals. However, in 6M and 12M Dual Momentum, downside is observed to a peak of -25 percent while upside goes over 60 percent in similar time frames. As investors, we like large upside movements, but would like to avoid large downside movements—a return stream Dual Momentum seems to provide.

These quirks aside, Sharpe ratios are still a useful rough measure to test risk-adjusted portfolio performance. In the 6M system, the Sharpe ratio is 0.733; in the 12M system, the Sharpe ration is 0.874. The 12M system has a higher Sharpe ratio, so 12M is better lookback period by this measure.

What's more, the Sharpe ratio advantage for the 12M system seems to be pervasive throughout our lookback period. Even when we strip out 6M's diverging years (1988-1993), the 12M system still has a better Sharpe ratio at 0.841 compared with 6M's 0.815. (Although this difference is much smaller and I would consider them to be statistically "almost equal".)

Newfound's 7 Period System

Next, we will take a closer look at Newfound's suggested system where the investor uses seven lookback periods to scale into and out of positions. Each system is re-balanced monthly as needed when trades are made; the impact of each system on the overall portfolio stays the same.

Setting aside trading frequency and cost for the moment, I have to say that Newfound's system does make logical sense. If the seven lookback periods have comparable expected long-term risk-adjusted returns, and if there are moderate differences between lookback periods, it should make a lot of sense for investors to spread their bets across a number of lookback periods.

In this way, each lookback period will have just 1/7th the impact on their total portfolio, but combined will still produce results very in line with a typical Dual Momentum investor's expectations. It would also help an investor avoid the effects of one underperforming lookback period in a given time frame.


Sources: TheRichMoose.com, MSCI Inc., FRED

In this backtest, the Newfound 7 system is clearly better than the traditional 12M system in avoiding large drawdowns. Newfound 7's total maximum drawdown is -19 percent while 12M plunges lower at -25 percent.

The drawdowns are also even more correlated. When Newfound 7's system is in drawdown, 12M is also in drawdown 92.4 percent of the time. Likewise, when 12M is in drawdown, Newfound 7 is in drawdown 94 percent of the time.

Over the entire testing period, Newfound 7 is in a drawdown slightly more often at 58.2 percent of months compared with 12M's 57.1 percent of months in drawdown. However, this difference is clearly negligible.


Sources: TheRichMoose.com, MSCI Inc., FRED

When comparing the two models, again the 12M system does slightly better overall. 12M returns +16.1 percent compounded annually while the Newfound 7 system returns +15.5 percent compounded annually. Once again, the divergence comes primarily from the period around 1990.

Sources: TheRichMoose.com, MSCI Inc., FRED

The rolling annualized returns shown in this chart are indicative of how closely correlated Dual Momentum is—especially in the longer lookback periods. These two systems' monthly returns are 96.0 percent correlated across this test period.

While we see the familiar divergence in returns in the late-1980s and early-1990s, for the rest of the test period the returns are very tight with few meaningful divergences. It is a fair statement to say the overall performance for the two systems are extremely comparable.

However, the 12M system line (green) is noticeably above the Newfound 7 system line (blue) almost all the time.

Sharpe Ratios

When we compare the two system's average annual returns, the 12M system is better than the Newfound 7. This is naturally reflected in the higher overall returns we see with the 12M system. What surprised me is that the Newfound 7 system had a higher standard deviation.

This ultimately translated to the 12M system boasting the Sharpe ratio of 0.874 as shared previously. The Newfound 7 system was somewhat lower at 0.818.


What stood out most for me in doing this backtest is the robustness of Dual Momentum as a system, regardless of the precise lookback period used. The performance is truly outstanding with very admirable downside protection. Critique is absolutely fair, but Gary Antonacci deserves a lot of credit for sharing this with the public.

While I could have made an extremely long post comparing each lookback period from 1-month through 12-months with cluttered charts and graphs, I think the tests shared here are an adequate representation of how Dual Momentum performs on the longer side of the academically reviewed time-series momentum tests. I could quickly show more if need be.

On lookback periods, I think the evidence is pretty clear. For some reason, the 12-month lookback does perform better than shorter lookback periods including the 6-month. 12-month lookbacks might not be better on every measure in every time period, but it's certainly an excellent option over full market cycles for self-directed investors.

When comparing 12-month DM to Newfound's 7 Period DM, I think Corey Hoffstein raised some important points. Scaling into and out of positions would have significantly reduced the maximum drawdown and also reduced the severity of most other drawdowns.

However, the important question is: Should a typical investor follow Newfound's suggested system to reduce risk in their portfolio?

Overall, I would say there are limited benefits to choosing Newfound's more complex system and there are some drawbacks.

First, we can't ignore that the two systems are extremely correlated at 96.0 percent. The difference in return stream offered by Newfound's system is very minimal. This is not a great way to diversify your portfolio. For perspective, U.S. stocks and International stocks only exhibit 70 percent correlation.

Second, the Newfound system would require significantly more trades. While I didn't count the trades for each system, a 6-month lookback trades twice as much as a 12-month lookback. Although trading costs are low, this is not insignificant. The true costs get higher for U.S. investors when considering capital gains taxes in a non-registered investment account.

Third, the Newfound system does underperform the 12-month system on an absolute and risk-adjusted basis. While we may not be able to explain exactly why, a 12-month lookback period for broad stock indices has done extremely well. The higher Sharpe ratio, driven both by higher absolute returns and a lower standard deviation does not appear mere coincidence. The 12-month system stands above other lookback periods almost all the time. When it does underperform, it is not by much.

For a self-directed investor who has moderately sized retirement accounts, the best way to deal with the fragility of Dual Momentum is by adding a completely different non-correlated investment style as a significant component of your portfolio.

For example, a long-short strategy, managed futures, a tail-risk strategy, or an options trading strategy may nicely complement Dual Momentum. (I should point out this is precisely what I do in my personal portfolio, so take this with an ounce of bias.)

If a self-directed investor grows their personal accounts to a substantial size, there are some benefits to introducing additional lookback periods into the Dual Momentum portfolio of their portfolio. As this backtest demonstrates, additional lookback periods are likely to reduce overall drawdowns.

However, seven periods might be a bit extreme for any investor. For example, a quick test shows comparable downside mitigation with just four periods (6-month, 8-month, 10-month, and 12-month).

There are other considerations. An investor with large accounts is likely more interested in preserving capital (avoiding big drawdowns) than growing wealth. Multiple lookback periods as part of a trading system can be quite beneficial when this is the investor's focus.

A professional fund manager offering a Dual Momentum style fund to wealthy clients is likely to benefit the most from introducing multiple lookback periods. Professional managers get penalized heavily for drawdowns (fee revenue loss and client withdrawals), their clients are likely to have other funds in their portfolio for adequate diversification, and they have to make regular small trades in their course of business to account for distributions and fund flows.

In conclusion, no investor with even moderate wealth should put all of their money into a single investment model. Models can look great in backtests and may even perform very well going forward; however, we cannot predict that 12M Dual Momentum will provide 5-year rolling annualized returns between 3 percent and 45 percent going forward. It could be better, it could be worse.

While momentum-based strategies like Dual Momentum can provide a reasonable guideline for investing that is preferable to blindly holding the index, it does not guarantee protection from sudden drawdowns that could significantly exceed past events.

The best we can do is follow a sound premise, diversify across assets and strategies as needed, and be prepared to invest counter to our emotional desires in the moment. The moment we override our strategy is the moment we no longer have a strategy. That is the real danger.

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RM Portfolios Update: January 2019

Welcome to the January update for the different portfolios which I track here at The Rich Moose blog.

I use Canadian-listed ETFs where possible for the models I share to keep the tracking, purchasing, and selling easy for Canadian readers. However, because they are not available in Canada, I use U.S.-listed 3x Leveraged ETFs and track returns in U.S. dollars for the Dual Momentum strategy and some of the Leveraged Barbell Portfolios.

See the list of my favourite Canadian ETFs on this page.

Vanguard All-in-One Portfolio ETFs

These Vanguard ETFs hold multiple assets inside a single ETF. It's nearly a perfect solution for investors who want to buy just one ETF and hold it forever without worrying about re-balancing, tax trigger issues, and excessive costs. Read my post reviewing these products to get an idea of how they are designed.

While I personally believe there are better ways to invest when you have a larger investment account, these Vanguard Portfolio ETFs are great for newer investors, people who don't want to spend any time thinking about their investing process, and investors who want to minimize costs that would otherwise use a "robo" advisor or a similar, more expensive passive investment approach.

Here are the January monthly & past 12-month returns of these portfolio products (benchmark data).

Vanguard Growth ETF (VGRO.TO)
January:  +4.69 percent
12-Month Return:  -0.14 percent

Vanguard Balanced ETF (VBAL.TO)
January:  +3.73 percent
12-Month Return:  +0.64 percent

Vanguard Conservative ETF (VCNS.TO)
January:  +2.83 percent
12-Month Return:  +1.45 percent

The decision between choosing the Growth ETF, Balanced ETF, or Conservative ETF depends on your tolerance for risk and your investment time-line. The Growth ETF should have the highest returns and highest draw-downs over time while the Conservative ETF will show lower returns with more stability. The Balanced ETF is a middle-of-the-road option.

12-Month Dual Momentum Strategy

Dual Momentum is a strict, rules-based investing approach which uses an easy performance evaluation to decide your investment holding for each month.

Most months the holding will stay the same; trades occur fewer than two times per year on average.

By evaluating just once each month, you can reduce the negative effects of market noise and spend very little time managing your investments.

I use Dual Momentum in my own personal portfolio. Looking at the history, I think Dual Momentum investors have a good opportunity to have market beating performance with lower drawdowns.

The Dual Momentum strategy—as tested by Gary Antonacci of Optimal Momentum—has shown fantastic results over complete market cycles. Read his website, book, and research papers to get a full understanding of how the strategy works.

In my model, I evaluate the holding each month based on the 12-month gross performance of the MSCI USA Index, the MSCI ACWI ex-USA Index, and the annualized past return of 3-month U.S. Treasury bills.

Each month I will share the model signal as either U.S Stocks, International Stocks, or Bonds. Read the linked posts to understand the investment options and other questions related to these signals. The signals and returns are calculated in U.S. dollars.

See how the Dual Momentum portfolio would have performed compared to a buy-and-hold index portfolio over the past 5 decades by visiting the Portfolios page.

Index 12 Month Performance:  -12.38 percent
Index January Performance:  +0.65 percent
Current recommendation:  Bonds

Leveraged Barbell Portfolios

The Leveraged Portfolio strategy uses a unique mix of short-term bonds and leveraged stock ETFs to achieve growth while limiting downside risks. It's essentially a barbell strategy where all the risk and growth is contained in a small portion of the entire portfolio.

Although I add a trend factor into the analysis for my personal portfolio, the strategy I use in my non-registered account works very similar to this Leveraged Barbell Portfolio.

If you choose to implement the strategy, make sure you treat each account as a whole portfolio. Do not put bonds in one account and leveraged stock ETFs in another account!

Leveraged portfolios are re-balanced just once per year. For this reason, I will always track the Year-to-Date returns only.

Canadian-listed ETFs (2x Leverage Stock ETFs)

HSU.TO (50%) & XSB.TO (50%):  +8.18 percent
HSU.TO (30%) & XSB.TO (70%):  +5.18 percent

U.S.-listed ETFs (3x Leverage Stock ETFs)

UPRO (40%) & BSV (60%):  +9.92 percent
UPRO (30%) & BSV (70%):  +7.59 percent

These allocations are just a few examples of how Leveraged Portfolios can work. Leveraged ETFs amplify positive and negative returns so they should always be paired with low-risk assets to meet your personal risk tolerance. In a non-registered account, you may use margin debt to purchase your stock index ETF for somewhat better tracking.

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.