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

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2 Replies to “How Does Dual Momentum Perform with Leverage”

  1. “I did a monthly readjustment on the leverage. This will vary somewhat from real-world results if you use a daily leveraged ETF… However, the results should be fairly close to both of these methods.” Daren

    I think the results could differ greatly between a daily leveraged ETF and your monthly readjustment model.

    Say you are 100% invested in an UPRO like ETF as per signalled by DM and a Black Monday type of event occurs: the 1 day loss would have been an epic 60% of your equity.

    But imagine this Black Swan event is not a 20% drop; but a 30% instead: you would have suffer a catastrophic 90% loss. All it takes is 1 miserable day to destroy your equity. It matters not if 15 days later the market rebounds to the previous peak.

    1. Daren (Editor) says:

      Thanks for pointing that out Yanniel, it goes without saying that it would be very reckless to have 100% of your portfolio 3x leveraged in a single position! That means daily rebalanced ETFs or otherwise. It’s one reason why I didn’t even model it out in this post.
      I talk about balancing 3x daily leveraged products with lots of bonds in your overall portfolio in other areas of the blog.
      Even 2x leverage is way too hot. As my example showed, a ~50% drop (on monthly readjustment) is huge. Especially when you count on the extreme results being 25% worse going forward (62%+ drawdown).
      I think 1.25x (daily leveraged ETF or with margin) is a pretty safe leverage amount for a more aggressive investor. More than that requires absolute discipline and balls of steel!

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