Dual Momentum: Evaluating the Bonds Component

This is the final post in a three post series of evaluating each signal within the Dual Momentum model: "U.S Stocks", "International Stocks", and now finally "Bonds".

In the Dual Momentum strategy, which I share each month with the blog readers, I use a customized 3-month Treasury bill rollover index to analyze 12-month performance of cash (the absolute momentum hurdle).

To calculate the past 12-month return of T-bills, I mimic what an investor would have achieved for a gross return if they had purchased a 3-month T-bill a year ago and rolled it into a new 3-month T-bill each time the T-bill expired, creating a compound return.

For example, if I was evaluating the cash return on November 30, 2018, I would simulate the following:

  1. Buys 3-month T-bill on December 1, 2017 and holds until maturity; then
  2. Buys 3-month T-bill on March 1, 2018 and holds until maturity; then
  3. Buys 3-month T-bill on June 1, 2018 and holds until maturity; and finally
  4. Buys 3-month T-bill on September 1, 2018 and holds until maturity.

At each T-bill rollover, the investor would invest their original investment and the interest they earned from the prior T-bills to generate a compound return of the four T-bills. The purpose is to mimic the 12-month return of holding the safest asset currently possible.

While I use the 3-month Treasury bill rollover index to generate the signal, each investor must choose a fund they will actually invest in when the signal is in "Bonds".

I do not recommend buying T-bills as you may need to hold them for less than 90 days, although you could buy a money market fund or cashable GIC if you don't want to use bond ETFs.

When it comes to bonds, there are almost countless choices for investors to implement this signal their portfolios.

Some of the most common bond fund types which are available in a low-cost ETF format include:

  • Aggregate bond funds—invests in all investment grade bonds of all maturities in a market weighted format
  • Short-term bond funds—invests in investment grade bonds up to 5 year maturities in a market weighted format
  • Government bond funds—invests in only government issued bonds
  • Corporate bond funds—invests in only corporate investment grade bonds

There are endless variants of the above, including corporate junk bonds, short-term government bonds, short-term corporate bonds, intermediate-term government bonds, intermediate-term corporate bonds, government TIPS bonds, international bonds, green bonds, etc.

Given all these options available, most at a relatively low cost, what should investors choose when the signal is in "Bonds"?

Aggregate Bond Funds

Gary Antonacci is very clear that he prefers using a low-cost aggregate bond index fund when the signal is in "Bonds".

Gary argues that aggregate bonds represent a safety asset that benefits from investors' shift from stocks to bonds during a stock bear market. As well, they benefit from loosening monetary conditions as central banks attempt to revive the business cycle.

Aggregate bond funds are highly liquid and available at extremely low management fees of 0.05 percent. They consist 70 percent AAA rated bonds, including government Treasury bonds, with the remainder from large corporate issuers.

Their average duration is approximately 6 years, pulled down mostly by the tilt to generally shorter duration on corporate bonds.

Given the inclusion of corporate bonds and long-term Treasury bonds, aggregate bond funds will see somewhat more volatility than a pure short duration bond fund.

Short-term Bond Funds

Short-term bond funds are much more stable than aggregate bond funds as they do not suffer from duration risks. These funds will not hold bonds with maturities longer than 5 years while the average duration is just 2.5 years.

The short-term bond funds typically have somewhat fewer government bonds as a percentage of total holdings than the aggregate bond funds. This is because many corporations issue short-term bonds.

Just 60 percent of bonds in short-term bond index funds are AAA rated bonds.

Short-term bond funds are available at extremely low management fees of approximately 0.06 percent. Like aggregate bond funds, they are very common from several low-cost providers and often highly liquid.

Given their short average duration, short-term bond funds are normally more stable and benefit less from loosening monetary conditions when compared with aggregate bond funds.

Government Bonds

Government bonds, in the context of U.S. Treasury bonds or even Canadian government bonds, are the most stable and secure form of credit investment.

Governments also issue the most investment grade bonds on the market. Funds holding government bonds are often highly liquid and available at a low cost as it is easy manage a fund with only one credit issuer.

Government bonds are issued across the entire duration curve, ranging from 1 month bills to 50 year bonds (Canada). Most commonly, the U.S. treasury issues 3-month Treasury bills through 30-year Treasury bonds.

Although there is inflation risk due to a floating fiat currency system, a bond holder of U.S. government debt is certainly going to be repaid. It would not make sense for the government to declare bankruptcy on their debt when they can just print more dollars to pay it off.

Corporate Bonds

Corporate debt securities range from AAA rated bonds through to unmarketable junk bonds. Investment grade credit, rated above BBB (Standard & Poors), is the most common corporate bonds for index ETF investors.

Corporate bonds suffer from inflation risk like government bonds, but they also suffer from default risk. If the government prints dollars and stokes inflation, corporations will benefit as their debt value decreases compared to asset value.

At the same time, if the corporation runs out of money, they will declare bankruptcy. This could be a near total default, or a partial restructuring where bond holders often take large losses.

The risk for corporate bond funds is higher than government bonds, but bond funds are well diversified so isolated bankruptcies are not likely to cause significant losses for corporate bond fund investors.

Due to the default risk on corporate debt, investors should avoid investing in long-term corporate bonds.

Junk bond ETFs do exist and are widely available; however, they are much more correlated to stock market performance than they are to bonds, especially in crisis periods. For this reason, you should avoid junk bonds in Dual Momentum!

Comparing Bond Options in Dual Momentum

Before we recommend any one option over another, we will evaluate the historical performance of several major bond fund categories when used in the Dual Momentum model.

Government Bonds

Due to a data issue, I will start with a comparison of short-term government bonds, intermediate-term government bonds, and long-term government bonds since 1978.

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 "Bonds", I put the portfolio either into short-term, intermediate-term, or long-term government bonds 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 1978 until October 2018.

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

In this backtest, long-term treasuries very clearly outperformed. The short-term bond option generated a 16.51 percent compounded annual return over the 40 year test period while the long-term bond option generated a 18.04 percent compounded annual return.

Clearly the intermediate bond option (average duration of 5 years) and the 10-year bond option were in the middle. You can see the month-to-month volatility on the 10-year line and it is a good reflection—amplified or reduced—of the monthly changes of the long-term, intermediate, and short-term bonds.

In my backtest, the long-term bonds were the best holding in nearly every single period where the signal was in "Bonds". Although long-term Treasury bonds were more volatile within the holding periods, the end result was repeatedly better.

Corporate Bonds and Gold

In this next backtest, I will compare short-term corporate bonds, aggregate bonds, and gold (often cited as a crisis asset) from 1987. The time period is shorter, again due to limited available data.

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 "Bonds", I put the portfolio either into short-term corporate bonds, aggregate bonds, or gold 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 1987 until October 2018.

Sources: TheRichMoose.com, MSCI Inc., FRED Federal Reserve St. Louis, Vanguard, London Bullion Exchange

In this comparison, the results for 10-Year Treasury bonds (the standard in my model), short-term corporate bonds, and aggregate bonds were very similar.

Gold underperformed significantly over most of the period, but made for lost ground in the 2000-2003 and 2008-2009 holding periods.

The top performer, 10-Year Treasury bonds, returned 14.62 percent compounded annually in this backtest while the bottom performer, short-term corporate bonds returned 14.24 percent compounded annually.

Although Gary Antonacci shares his preference for holding a low-cost aggregate bond fund when the signal is in "Bonds", 10-year Treasury bonds performed slightly better in nearly every holding period.

This may be a reflection of Treasury's preferred safety during crisis events and the slightly longer average bond duration.

Summary

At the end of the day, the asset of choice for the end investor when the signal is in "Bonds" is largely meaningless when comparing the major options: U.S. Aggregate Bond funds, Intermediate Treasury Bond funds, 10-Year Treasury Bond funds, or Long-term Treasury Bond funds.

If the Dual Momentum investor wanted to pursue the highest possible returns with the increased risk, Long-term Treasury Bond funds would be the better choice.

I believe U.S. Aggregate Bond funds, 10-Year Treasury Bond funds, or Intermediate Treasury Bond funds are all good choices for the typical Dual Momentum investor. Short-term bond funds are probably unnecessarily safe for most investors.

As always, choose a low 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 Dual Momentum signal is in "Bonds":

  1. We could choose XBB.TO/VAB.TO/ZAG.TO which invest in the aggregate Canadian bond market at 0.08 MER; or
  2. We could choose ZDB.TO or HBB.TO which are more tax efficient choices of the above at 0.09 MER; or
  3. We could convert our accounts to U.S. dollars and invest in a number of ETFs that hold aggregate bonds, long-term Treasury bonds, or intermediate Treasury bonds all for under 0.07 MER.

Comments & Questions

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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.

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.