Dual Momentum: Evaluating the U.S. Stocks Component

In the Dual Momentum strategy, which I share each month with the blog readers, I use the MSCI USA Index to analyze 12-month performance of U.S. stocks.

The MSCI USA Index is a broad market-cap weighted index that contains 70 percent large cap stocks with a 30 percent exposure to mid-cap and small-cap stocks. It is not available in ETF format to most investors.

While I use the MSCI USA Index to generate the signal, each investor must choose an investable index in a low-cost ETF format to get the required exposure to U.S. stocks.

When it comes to "U.S. Stocks", there are almost countless choices investors have to implement this signal their portfolios.

Some of the most common U.S. stock indices which are available in a low-cost ETF format include:

  • S&P 500—the largest ~500 publicly listed corporations in the U.S. weighted by market cap
  • S&P Total U.S. Market Index—approximately 3,500 publicly listed corporations ranging from large-cap to small-cap, weighted by market cap
  • Russell 2000—the U.S. markets' 1000th through 3000th largest companies reflecting most of the mid-cap and small-cap corporations

There are also comparable indices offered by competitors including S&P, FTSE Russell, and CRSP.

To add to the confusion, there are now almost endless factor variations of these primary indices which are available in ETF format for slightly higher management fees. These include growth indices, value indices, fundamental indices, equal weight indices, and many other factor tilts.

Given all these options available, most at a relatively low cost, and every one of them boasting certain advantages to the end investor, what should investors choose when the signal is in U.S. stocks?

S&P 500 / Large Cap Stocks

Gary Antonacci is very clear that he prefers using U.S. large cap stocks, via the S&P 500 Index, to invest in U.S. stocks for the Dual Momentum strategy.

There are some benefits to Gary's choice. First, on the surface, S&P 500 stocks are slightly less correlated to International stocks on a monthly basis.

Second, the S&P 500 Index has slightly better performance in the best years and slightly better performance in the worst years compared to the total U.S. stock market in the past three decades.

At the same time, it's important to point out that these differences are very slight and they vary by time period. Time period selection is a major fault in data mining for perfect results.

An S&P 500 Index ETF can be purchased for essentially no cost on the U.S. stock exchanges. If your brokerage allows you to share in profits from short lending against your holding, you may actually be cost negative on your position as the short lending profits can outweigh your management fees.

The Dow Jones Industrial Average is another "blue-chip" large cap index. Although it is often quoted by the media and is the oldest U.S. market index in current use, it is a flawed index in many ways.

Influence by share price instead of market cap, limitation to just 30 companies, and frequent changes to portfolio composition make the DJIA unappealing to many investors. It is also limited to just a few ETFs, none of which are particularly low cost.

Total U.S. Stock Market

The total U.S. stock market ETFs are my current method for investing in Dual Momentum when the signal is in U.S. stocks. The total market consists of approximately 80 percent exposure to the S&P 500 stocks with the balance in mid-cap and small-cap stocks.

Like the S&P 500 Index, the total U.S. market index ETFs are available at extremely low costs and can actually be cost negative with short lending benefits.

Some of the most common total market indices available in ETF format include the S&P Total U.S. Stock Market Index, the CRSP US Total Market Index, the FTSE US Total Market Index, and the Russell 3000 Index.

The total U.S. stock market provides the most complete exposure to the U.S. stock market as it covers most of the investable market space weighted by market cap.

Russell 2000 / Smaller Cap Stocks

Another option, often touted by the buy-and-hold crowd, is investing in small cap stocks to benefit from the small cap premium.

When compared consistently in a buy-and-hold format against the S&P 500 and the total U.S. market, the small caps have clearly outperformed. Their returns are higher by nearly 1.5 percent per year!

However, they are also about 30 percent more volatile than the large caps. The historical performance shows much better good years and much worse bad years.

In many ways, the Russell 2000 is more reflective of the underlying U.S. economy as these companies are much less likely to have a significant amount of overseas revenue.

Comparing These Options in Dual Momentum

Before we recommend any one option over another, we will evaluate the historical performance of these three major asset choices when used in the Dual Momentum model.

For these backtests, I maintained the exact same signals using the MSCI indices which I use for all my Dual Momentum analysis.

When the base signal was in U.S. stocks, I put the portfolio either into the S&P 500 Index, a simulated total U.S. market index, or the simulated small cap index to represent the Russell 2000 for each time period. This in effect isolates the performance of each option so you can see how it works in the Dual Momentum model.

The backtest runs from January 1972 until October 2018.

Sources: TheRichMoose.com, MSCI Inc., AQR Dataset, Prof. French Dataset, FRED Federal Reserve St. Louis

Interestingly, the small cap index was the best U.S. market asset to use during most of the Dual Momentum model's timeline.

Small caps were also the most volatile, although this is somewhat hidden by the graph. Remember, I used period performance instead of individual monthly performance.

It was only in the 1990s and 2017-2018 that the large caps outperformed the small caps within the model.

Another important point is the high correlation and tight returns of the three primary choices. Through the end of 2017, the S&P 500 choice returned 16.50 percent compounded annually, the total U.S. market returned 16.36 percent compounded annually, and the small caps returned 16.47 percent compounded annually.

That means the choice differed by just a maximum of 15 basis points over the entire period with each choice beating the others over small time-frames within the entire period.

At the end of the day, the investment of choice when the signal is in U.S. stocks is largely meaningless when comparing the three primary options: large caps, small caps, and the total market.

For this reason, I believe it is best to choose the lowest cost option that is highly liquid to minimize drags in returns caused by management fees and bid-ask spreads.

In Canada, this leaves us with three viable options to invest when the signal is in U.S. stocks:

  1. We could choose XUU.TO which invests in the total U.S. market at just 0.07 MER; or
  2. We could choose VFV.TO which invests in the S&P 500 at just 0.08 MER; or
  3. We could convert our accounts to U.S. dollars and invest in several different low-cost ETFs that track the total market, large caps, or small caps all for around 0.05 MER.

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4 Replies to “Dual Momentum: Evaluating the U.S. Stocks Component”

  1. This is a gem: “your brokerage allows you to share in profits from short lending against your holding,”

    I was not aware this was something brokers would do. Could you mention example of brokers in Canada doing so?


    1. Daren (Editor) says:

      I know that Interactive Brokers does if you have a larger account ($100,000+ I believe). They split the short lending profits with you 50/50. There are a few conditions, but by and large it’s simple and has little impact on the average person’s investing process.

  2. My guess is that the sharing of short lending profits is only relevant for non registered accounts, right?

    1. Daren (Editor) says:

      Yes that’s correct. Registered account holdings can’t be used for short lending.

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