Dual Momentum: Why It Beats the Index

Since 1970, when International equity data became widely available thanks to the MSCI EAFE index, a portfolio invested in Dual Momentum would have substantially outperformed its individual components.

Dual Momentum has outperformed the U.S. stock index by about 6% per year; it outperformed International stocks by around 7% per year; and it outperformed bonds by nearly 10% per year.

Dual Momentum would have outperformed a buy-and-hold indexing portfolio of these three components, equally weighted and re-balanced annually, by roughly 7% per year. With a lot less volatility and lower drawdowns.

Picking the Right Investment at the Right Time

The reason Dual Momentum has stellar performance, beating its own components, with minimal drawdowns is because it (in a rough sense) picks the right asset to be invested in at the right time.

When U.S. stocks are beating International stocks and bonds, Dual Momentum will often have you entirely invested in U.S. stocks. We saw this happen in the period of 1995 through 1999 where Dual Momentum would have you invested in U.S. stocks in all but three months during this time.

Likewise, in the period of 2003 through 2007, when the investment world was buzzing around resources, peak oil, copper booms, the BRICs, and European property prices, Dual Momentum would have your entire portfolio invested in International stocks.

You would also been invested entirely in International stocks in the late 1970s and in the mid 1980s.

Just as importantly, Dual Momentum helps you avoid the worst of those long downturns in equity markets. You would have moved to bonds in at the end of 1973 and until early 1975, again in 1981-1982, also for the bulk of the 2000-2003 crash, and finally in 2008-2009.

Achieving positive returns in your portfolio while equity markets are getting slammed is a huge advantage!

The biggest drawdowns in Dual Momentum occurred during the 1973-1974 correction and the 2008-2009 market crash. In both of these huge events, your total drawdown would have been around 20%. (The true drawdown is just a best estimate as bond return data is hard to obtain for the 1970s.)

Don't forget that U.S. stocks and International stocks dropped well over 40% during these market events, sucking down buy-and-hold index portfolios with them.

Over the course of an entire bear market, Dual Momentum handily beats a buy-and-hold approach. In nearly every bear market event, Dual Momentum portfolios would have smaller and shorter drawdowns compared to a passive buy-and-hold index portfolio.

To get a visual of how Dual Momentum performs compared to an annually re-balanced equal weight portfolio, here's a logarithmic chart for the backtest period.

Sources: See Portfolios page

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Dual Momentum: Changing the Assets

Although Dual Momentum is often thought of as a prescribed investment strategy, it is in fact a concept on how to evaluate the recent performance of various asset classes to each other using two measurements of price momentum.

In traditional Dual Momentum—as popularized by Gary Antonacci—there are just three assets being evaluated based on the prior 12-month return.

The momentum measurements used are relative momentum and absolute momentum. Relative momentum, sometimes also referred to as cross-sectional momentum, compares the recent performance of two assets which are broadly in the same asset class. Absolute momentum, also called time-series momentum, compares the recent performance of one asset to the risk-free rate of return (represented by T-bills).

Dual Momentum was coined as such because the strategy uniquely uses both forms of momentum. Relative momentum is the first step of the Dual Momentum process where two broad equity categories—U.S. stocks and International stocks—are evaluated against each other. The best performing of those two assets are then evaluated on an absolute momentum basis to ensure positive performance over the risk-free rate of return.

Why Just 3 Assets?

Just as momentum can be evaluated on various time frames, the principles of Dual Momentum can be applied to nearly an infinite number of investment assets. You could compare individual stocks (RY.TO vs. CM.TO), equity sectors (XEG.TO vs. XMA.TO), bonds (XSB.TO vs XLB.TO), metals (CGL-C.TO vs SVR-C.TO), and so on. You could also mix these different classes or add them to standard Dual Momentum.

Given the endless possibilities, why does Gary just evaluate three different major asset classes?

For a few simple reasons, to reduce whipsaw costs, to reduce drawdowns, and keep the program simple to follow. Also, if there is any benefit to adding more assets to track, it is extremely minimal and comes with certain costs.

Here are a few examples adding different asset classes such as precious metals, separating emerging markets and developed markets, and adding real estate.

Backtest Results: Basic Dual Momentum (20 years)

Annual CAGR: +9.98%
Largest Drawdown: -18.93%
Sharpe Ratio: 0.70

Backtest Results: Dual Momentum Separate Developed and Emerging (17 years)

Annual CAGR: +11.86%
Largest Drawdown: -24.68%
Sharpe Ratio: 0.77

Backtest Results: Basic Dual Momentum + Precious Metals (20 years)

Annual CAGR: +11.82%
Largest Drawdown: -44.66%
Sharpe Ratio: 0.53

Backtest Results: Basic Dual Momentum + Real Estate (20 years)

Annual CAGR: +10.20%
Largest Drawdown: -22.09%
Sharpe Ratio: 0.65

Backtest Results: Dual Momentum + Precious Metals + Real Estate (17 years)

Annual CAGR: +9.93%
Largest Drawdown: -44.66%
Sharpe Ratio: 0.46

As you can see by the results, on a risk adjusted basis the standard Dual Momentum model shows fantastic results while keeping very low drawdowns.

Over the comparable time period, Dual Momentum beat an equal weight portfolio (1/3rd U.S. stocks + 1/3rd International stocks + 1/3rd Total Bonds) by more than 3.5% annually compounded. Not only that, the maximum drawdown with Dual Momentum was just one-third the size of the drawdown of the equal weight portfolio.

Adding more components can actually harm rather than improve investment returns. For example, adding precious metals to the standard Dual Momentum will increase returns by 1.84% annually—albeit with significantly larger drawdowns.

However, adding a fifth diversifying asset class to the Dual Momentum portfolio—real estate—actually reduces returns a bit while drastically increasing drawdowns. It also results in twice as many trades over the same time period. Many of those trades have negative returns for the holding period where it would have been better to hold the original asset. These are considered whip-saw trades and can do considerable damage when repeated frequently.

Understanding the Objective

The purpose of Dual Momentum, the standard three asset version, is not to only obtain maximum investment returns. The best way to get better returns is with leverage (and more risk), not applying momentum.

The goal of Dual Momentum in my estimation is to provide higher risk-adjusted returns. That is, larger returns than the standard indexing or buy-and-hold approach with lower drawdowns and volatility.

When it comes to choosing your personal investment approach, it is very important to evaluate your investment goals and what you expect your investment strategy to provide. There are the so-called robo-advisers and Vanguard Portfolio ETFs for the minimal efforts folks out there. The issue is managing drawdowns.

If you are worried about large drawdowns, you can choose a conservative allocation and get reasonable returns. With a standard indexing buy-and-hold approach, you would need at least 60% of your portfolio in bonds to bring drawdowns under 20%.

A conservative allocation like that would have generated an annual return of approximately 8.9% since 1972 for a real inflation-adjusted return of 5.2%.

However, if you don't mind doing a few quick calculations once a month and changing your investment holding once or twice per year, the standard Dual Momentum strategy would have returned over 17% annually. That's an inflation-adjusted return of 13.5% over the same time period.

Results Matter

A $100,000 portfolio invested in a conservative buy-and-hold approach in 1972 would have grown to a respectable $5,050,000 today.

That same $100,000 invested in standard Dual Momentum would be worth $148,140,000 today. Thanks to greater compounding returns and lower drawdowns, you would be a centi-millionaire rather than a regular middle-class fogey.

Dual Momentum does an excellent job helping investors avoid those large drawdowns of prolonged bear markets. For example, the market cycles over 1973-1974, 2000-2003 and 2007-2009 downturns were perfect for Dual Momentum.

The standard three-fund Dual Momentum strategy accomplishes its objective very well with minimal effort. Adding more assets to the strategy adds to drawdowns and trading frequency—two very big drawbacks for your typical self investor.

Comments & Questions

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