Dual Momentum: Evaluating the International Stocks Component

This post hopes to address a frequent line of questions I get about the Dual Momentum signal I share monthly on this blog.

  • Why did I just post an MSCI EAFE Index ETF as my international signal?
  • Is it a big mistake to invest in the international developed stock market without emerging markets?
  • What about Canadian stocks which are not in the MSCI EAFE Index?

Some of the questions are addressed in an Update on Dual Momentum post. As stated there, I am changing the format and signals of the Dual Momentum update I share each month.

The International Stock Component

We can break the International ex-U.S. equities markets into two broad groups: developed markets and emerging markets. There are also frontier markets, but these are often not investable for various reasons.

The developed markets make approximately three-quarters of the international ex-U.S. market cap. Stock markets include most of western Europe, Japan, Australia, New Zealand, and Canada.

The most popular developed market index is the MSCI EAFE Index which does not include Canada or South Korea. The alternative developed index is the FTSE Developed ex-U.S. Index which does include Canada and South Korea.

Depending on the index used, emerging markets currently form approximately 20 to 25 percent of the global ex-U.S. markets. This is set to grow rapidly in the future as the second largest market in the world—the Chinese domestic market—opens up to foreign investors.

The emerging markets includes 24 developing economies on every continent with reasonably investable financial markets. The most popular indices are the MSCI Emerging Markets Index and the FTSE Emerging Index.

There are slight variations in the MSCI and FTSE indices. The big ones are the inclusion of Canada and South Korea in developed markets, and the degree of inclusion for the Chinese domestic market (A-shares) in the emerging markets.

In the total accessible stock market space right now, U.S. stocks form about one-half of the global market cap and the rest of the world makes up the remaining half.

Do Emerging Markets Matter to Dual Momentum

As stated above, for 2018, I used the MSCI EAFE Index to measure International equities in my TADM model. One of the questions I get asked is if emerging markets should be included.

Before we jump to any conclusions about this, we should do a proper evaluation on precisely how much of an impact emerging markets have on our Dual Momentum model.

For this backtest, we used the MSCI USA Index, the MSCI World ex-USA Index, the MSCI ACWI ex-USA Index, the FRED 3-month Treasury Bill data for cash, and the NYU calculated 10 Year Treasury Bond data with for our out-of-market investment.

Emerging markets have only been tracked since 1987, so we will look at performance from that time forward.

Sources: TheRichMoose.com, MSCI Inc., FRED Federal Reserve St. Louis

Based on the graphs, emerging markets do matter. But maybe not as much as you think.

From 1987 to 2017, the backtest which included emerging markets generated a 14.76 percent compound annual return. This compares to a 14.08 percent compound annual return for the backtest using developed markets only.

The advantage was negligible for the first few decades, but in the mid-2000s it significantly tilted towards emerging markets.

We don't know the future, but a potential 0.7 percent annual advantage adds up as time works its magic.

Given the information we know with current data, you should invest in a global market ETF which includes emerging markets when the signal is in International stocks if that is feasible.

In Canada, this leaves us with two viable options:

  1. We could convert our accounts to U.S. dollars and invest in U.S. listed ETFs where several low-cost global ex-U.S. ETFs exist; or
  2. We could invest 75 percent of our portfolio in a developed market ETF and 25 percent in an emerging market ETF.

Both of the options add further complication to our investing process. It does not make sense for all Canadian investors to take these extra steps.

If you have more than $10,000 per account and you invest with a brokerage that charges no fees on many ETF transactions like Questrade or National Bank Direct, you should consider buying a developed market ETF and an emerging market ETF as in option 2 above.

If you have an account balance of at least $50,000 per account, you could consider switching to a U.S. dollar account and investing in U.S.-listed ETFs for all of your Dual Momentum holdings.

You can keep costs low by using Norbert's gambit with DLR/DLR.U, or Interactive Brokers to change currencies. Remember, not all brokerages offer U.S. dollar accounts, particularly for registered accounts.

Does Canada Matter to Dual Momentum

Since in the TADM model I have shared an ETF which tracks the MSCI EAFE Index (which does not include Canada), another common question I get relates to the impact of not having Canadian stocks in the Dual Momentum model.

Before we jump to any conclusions about this, we should do a proper evaluation on precisely how much of an impact Canadian markets have on our Dual Momentum model.

For this backtest, we used the MSCI USA Index, the MSCI All Country World ex-USA Index, the MSCI EAFE+EM Index, the FRED 3-month Treasury Bill data for cash, and the NYU calculated 10 Year Treasury Bond data for our out-of-market investment.

The only difference between the MSCI ACWI ex-USA Index and the MSCI EAFE+EM Index is the latter does not include Canada.

You will notice we have to run the test from 1987 forwards given that emerging markets were included at that time and we need to get an effective comparison test of Canada's impact in our broad investment options today.

Sources: TheRichMoose.com, MSCI Inc., FRED Federal Reserve St. Louis

When isolated as best as I can, the impact of Canada is very real.

The return of the MSCI ACWI model, which includes Canada, was 14.76 percent compounded annually over the 30 year period.

If we just used the MSCI EAFE+EM index, the return was 14.19 percent compounded annually.

We could say that inclusion of Canadian stocks translates to a 0.57 percent annual return advantage over the entire period.

However, until the mid-2000s there was no real difference. As with emerging markets, the impact of Canada is strongly related to the natural resource boom.

We do have a lower cost ETF on the Canadian exchange which tracks a developed market index that includes Canada. It is the Vanguard FTSE Developed All Cap ex-U.S. Index ETF (VDU.TO).

The problem with this VDU.TO compared to the ETF I share—XEF.TO—is the structure behind it.

While iShares XEF.TO holds stocks directly, Vanguard's VDU.TO holds the U.S.-listed counterpart ETF: VEA. This causes VDU.TO to have an unnecessary extra layer of withholding taxes, taking between 0.30 and 0.35 percent off the overall return each year at current dividend yields.

Another advantage to XEF.TO is its superior liquidity. There are about 6 times as many shares outstanding and about 4 times as many shares traded each day compared with VDU.TO. Given that Dual Momentum calls for complete account turnovers, this can have an impact, especially on larger portfolios.

If we add the impact of the withholding taxes alone, the return advantage of investing with VDU.TO compared to XEF.TO would have shrunk to approximately 0.25 percent. If you add the liquidity costs, this could conceivably shrink down quite a bit more.

In Canada, this leaves us with two viable options to tackle this issue:

  1. We could choose VDU.TO instead of XEF.TO, in addition to our emerging markets ETF; or
  2. We could convert our accounts to U.S. dollars and invest in U.S. listed ETFs where several low-cost global ex-U.S. ETFs exist which include Canada in their holdings.

Again both of these options complicate our investment process for Canadians.

If you have a smaller account where liquidity is not a major problem, I would recommend using Vanguard's ETF pair. This means a 75 percent allocation to VDU.TO and a 25 percent allocation to VEE.TO when the signal calls for International stocks.

For larger accounts, we are back to switching our accounts to U.S. dollar accounts and buying U.S.-listed ETFs.

You will notice I do not think adding a Canadian ETF to the iShares ETFs is a good option.

Canadian stocks make up less than 6 percent of the All-World ex-U.S. markets. In my view, it would not make sense to hold three ETFs when the signal is in International stocks.

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Updating Dual Momentum

Dual Momentum is a very robust and simple trading system that can be followed by any individual managing their own money. It's a great strategy for RRSPs, TFSAs, RESPs, and non-registered investment accounts.

Gary Antonacci publicized the Dual Momentum with some white papers on asset class momentum shortly after the Financial Crisis.

The papers were a big hit at a time when investors were still fresh experiencing massive portfolio drawdowns, so Gary wrote a book on the strategy which you can buy on Amazon. I recommend you read it if you are interested in this strategy.

About Dual Momentum

If you are looking for a simple strategy that requires very minimal effort to maintain and reduces drawdowns over market cycles, Dual Momentum may be the answer. It takes its name from the two evaluations you performance once every month: a relative momentum evaluation and an absolute momentum evaluation.

In Gary's original form, he does a 12-month lookback on two equity assets. The first equity asset class is the U.S. market via the S&P 500 Index. The second is the MSCI All Country World ex-USA Index which includes most of the world's investable equity markets outside of the United States.

The equity asset with the highest total return over the past 12-months is put up against the risk-free rate of return over that same time period, represented by Treasury bills.

If the equity asset return beats the risk-free (T-bill) return, you invest in the winning equity asset via a low-cost option like ETFs or index mutual funds. If the T-bill wins, you invest in a broad bond fund.

Since 1950, Gary estimates the Dual Momentum model would have returned 15.8 percent annually before fees and taxes. Drawdowns, measured monthly, would not have exceeded 17.8 percent. It's a truly amazing result that handily beats a buy-and-hold approach.

My Time Averaged Dual Momentum

Approximately one year ago, I created my TADM model based on Gary's research. It is designed for Canadian investors who want to trade with low-cost ETFs available on the local stock exchange.

In my model, I have taken the average of the 6-month return and 12-month return, and used that to evaluate the relative momentum of the two equity assets instead of the traditional 12-month return.

This averaging technique creates a more responsive system. Trades are often entered a month or more sooner than the standard Dual Momentum model. However, the cost is a few more whipsaw trades.

The assets I originally used are the MSCI USA Index, the MSCI EAFE Index, and short-term bonds.

Although the MSCI USA Index is not available in ETF, the S&P U.S. Total Market Index is, and it covers much of the same exposure. We have several options for the MSCI EAFE Index and the comparable FTSE Developed ex-North America Index.

My TADM model has shown great results in backtests as well. Although I don't have access to the monthly data on a broad range of measures like Gary does, since 1970 my TADM model would have returned about 16 percent per year.

The nice part about Dual Momentum is that it is extremely robust. No matter what timing period or which precise index is used, the results are always very similar. Annual returns in the 15 to 17 percent range, low maximum drawdowns under 25 percent, and relatively few trades to achieve these outstanding results.

Playing Dual Momentum Games

After doing a lot of testing of different Dual Momentum inspired models in the past few weeks, I've decided I'm going to change my shared signal and effectively kill the MSCI EAFE-based TADM model.

There's a few reasons for this, some of which will be explained in more detail in some upcoming posts. But it essentially boils down to Occam's razor. When two competing strategies are compared side-by-side with similar results, you should choose the strategy that is the simplest and most efficient.

TADM is the product of unnecessary complexity without the meaningfully different results. In a lot of other areas in my trading and when I communicate with readers, I frown on data mining to search for the "perfect" investment approach.

To be clear, data analysis is very useful when you are trying to test the robustness of a particular investment strategy. You want to invest in a strategy that shows similar results across similar parameters.

If you have a system that's based on a 12-month lookback period which returns 10 percent per year, but if you change to an 11-month lookback your results are wildly different—say 25 percent per year—you should be very suspicious of the likelihood of the system being valid going forward.

However, if your 12-month system returns 10 percent annually, the 11-month system returns 10.6 percent, the 10-month system return 9.5 percent, and so on, the system is showing consistency and is more likely to meet your expectations going forward.

If you have a robust system, like Dual Momentum, then it is best to stick with the simplest approach with the easiest execution. The simple 12-month backtest does exactly that.

Testing Dual Momentum Timing

In the following backtests, I ran systems using data that is closer to Gary's data. Namely, the MSCI USA Index (I can't get monthly return data on the S&P 500 or S&P U.S. Total Market Index), the MSCI World ex-USA Index (1970-1988), the MSCI ACWI ex-USA Index (1988-2017), 3-month Treasury bill rates, and 10-year Treasury bond returns.

In my backtests, it is clear that a 6-month lookback on its own is sub-optimal. The returns are still impressive at a little over 15 percent annually, but the number of trades increased quite a bit over the backtest period.

A 12-month lookback produces quite spectacular results. Again, although my index data and bond data is different, it approximates the results of Gary's model with a 16.95 percent annual return from 1970 through 2017.

The TADM model with the same data as the other tests, but uses an average of the 6-month and 12-month performance, produces great results as well with a 15.95 percent annual return.

Here's what the results of each model look like in a chart format.

Sources: TheRichMoose.com, MSCI Inc., FRED Federal Reserve St. Louis

If you look closely at the chart, you can pick out the winning periods for each timing mechanism. The 6-month lookback did well in the 1970s and 2000s, the 12-month lookback did well in the 1990s and 2010s, and the TADM lookback did well in the 1980s.

None of the models showed any horrible drawdowns, just like none showed any outlandishly better returns in any given period. Instead, it was a matter of one system shining a bit brighter than the rest at certain times.

When all taken together, using the broadest data I can get my hands on (the MSCI World ex-USA instead of the MSCI EAFE) and the safest measurement for cash (the 3-month Treasury bill), the 12-month lookback shone the brightest overall.

That is despite the signals being the exact same for the TADM model and the 12-month model almost all the time.

Changing My Dual Momentum Signal

Going forward, I'm going to be changing the method and terminology of my Dual Momentum signals.

First, I will only state: "U.S. Stocks", "International Stocks", or "Bonds". I will leave it to you to decide on how you exactly want to execute the signal on your end.

Here are some low-cost options to consider:

  • U.S. Stocks
    • Buy a Canadian-listed ETF that tracks the S&P 500, S&P U.S. Total Market, or other U.S. stock index
    • Buy a U.S.-listed ETF which tracks the S&P 500, S&P U.S. Total Market, Russell 1000, Russell 3000, or another U.S. stock index
  • International Stocks
    • Buy a Canadian-listed ETF that tracks the MSCI EAFE, FTSE Developed ex-U.S., or another similar developed market index
    • Pair the developed market ETF with a 25 percent exposure to a Canadian-listed emerging market ETF tracking the FTSE Emerging Markets, MSCI Emerging Markets index, or similar emerging market index
    • Buy a U.S.-listed ETF which tracks the All Country World ex-USA, FTSE All-World ex-U.S., or a similar global stock index
  • Bonds
    • Buy a Canadian-listed ETF that holds short-term or broad bonds with a mix of government and corporate debt
    • Buy Canadian government bonds through your brokerage
    • Buy tax-friendly Canadian bond ETFs
    • Buy a U.S.-listed ETF which holds short-term Treasury bonds, medium-term Treasury bonds, short-term corporate bonds, or a broad bond fund
    • Buy U.S. government bonds through your brokerage

Second, I will be basing my signals on a 12-month lookback period only using the MSCI USA Index, the MSCI ACWI ex-USA Index, and rolling 3-month Treasury bill returns over a one year period. All will be measured in U.S. dollars.

This changes from my former model where I used Canadian-listed ETFs for the performance signal and had the time averaged timing periods.

If you have been following my TADM model so far this year, don't freak out. The signals only changed slightly and my TADM model actually outperformed the 12-month model by 1.15 percent this year. Going forward it means fewer trades and very similar returns.

Comments & Questions

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