Dual Momentum: Relative or Absolute Momentum First?

When Gary Antonacci first shared the Dual Momentum strategy, he outlined a specific process that DIY investors could follow to narrow their investment of choice using absolute momentum (time-series momentum) and relative momentum (cross-sectional momentum).

Both forms of momentum are demonstrated by ample academic research as generating better risk-adjusted returns compared to simply holding the underlying security in all market conditions.

Gary was the first person to publicly share the outsized returns an investor can achieve by combining the two forms of momentum using major asset classes. He called this investment strategy "Dual Momentum" and it has become very popular among self-directed investors.

Dual Momentum is noted for its simplicity. The strategy only uses three broad asset classes: U.S. Stocks, International Stocks, and Bonds. The investor uses a 12-month lookback period to find the recent returns of each asset class and then follows a simple process to get the "Dual Momentum signal" for the next month.

Gary Antonacci's Process

As you can see, the process is simple and covers both forms of momentum: absolute momentum and relative momentum. Gary tests for absolute momentum on U.S. stocks first in his process. This means an investor would neither be invested in U.S. nor International stocks if the U.S. equity market was underperforming Treasury bills.

While this model is simple to follow, my first thought as an investor based outside of the U.S. was: why test absolute momentum on U.S. stocks first? What if the rest of the world is performing well while U.S. stocks are experiencing a correction?

By testing absolute momentum on U.S. stocks first, we open ourselves up to single market risk. There is a real possibility of being invested in U.S. bonds while global stocks and global currencies were doing well. This would compound the downside from a global purchasing power standpoint.

In his book, Gary shares that U.S. stocks lead markets. Based on this thesis, an investor could test for absolute momentum on U.S. stocks first as a type of leading indicator on all equities. While this argument has certainly held true for most of the past century, I'm not so sure it will persist.

In the 1900s, we saw a major shift to a U.S.-based global economy. The U.S. economy dominated the world and global currencies were almost exclusively pegged against the dollar (via gold standard or trust in U.S. institutions). In fact, during the second World War this arrangement was formally adopted via Bretton Woods.

However, in recent decades other economies have increased their influence substantially. The People's Bank of China, the European Central Bank, and to a lesser extent the Bank of Japan carry a lot of weight. We are entering a period where the U.S. is slowly receding in relative economic dominance. This could hurt investors who rely solely on U.S. stocks to drive portfolio returns.

Considering the Dual Momentum model provides global diversification, I could understand a case for testing absolute momentum first if the test was applied to the global stock universe. We could evaluate the absolute momentum of the MSCI ACWI Index to determine if we should invest in stocks or bonds.

If the absolute momentum test determined global stocks were outperforming cash, we could run a relative momentum test to determine if we should invest in U.S. stocks or International stocks. In large part the relative momentum gains realized by the investor are driven by currency changes. U.S. stocks tend to outperform when the U.S. dollar is doing well against other global currencies; International stocks do well for U.S. investors when global currencies are outperforming the U.S. dollar.

That said, there is an easier way to do this without having to track another indicator. It would also keep the currency performance impacts separate.

My Dual Momentum Process

In my process, I test the relative momentum component first.

I begin by identifying which broad stock market class is performing better: U.S. stocks or International stocks. Once we've identified the stronger of the two major equity markets, we ensure we are investing in a rising asset by checking the absolute momentum of that market.

In this slight variation of the process, we can eliminate the risk of holding bonds while foreign stocks and currencies are doing well.

Relative Momentum First or Absolute Momentum First: U.S.A.

Sources: TheRichMoose.com, MSCI Inc., FRED

When comparing the two methods of Dual Momentum using U.S. stocks as the base, there is a slight historical performance advantage for testing absolute momentum first.

In this backtest, both methods are very comparable over the test period with the only substantial deviation occurring in the early-1970s. Even in this period, my suggested method quickly caught up to Gary's method by the end of the decade.

In the end, an investor testing for absolute momentum on U.S. stocks first (Gary's method) would have realized a +16.14 percent compound annual return during the test period.

The same investor testing for relative momentum of equities first (my method) would have realized a +15.93 percent compound annual return. This is effectively an indiscernible difference.

We can also look at a rolling period return to examine the differences in returns between the two methods more closely.

Sources: TheRichMoose.com, MSCI Inc., FRED

Testing absolute momentum first with U.S. stocks does show a general advantage earlier in the test period. The noticeably better performance at the start of the testing period largely stems from a single month in 1973 where the relative momentum first model had the investor in International stocks while the absolute momentum first model had the investor in bonds.

While one month does matter, we can't ignore the snap back in the following years where the relative momentum first model quickly caught back up.

The performance advantage of Gary's model has shrunk to nothing in the past two decades. I suspect this may be due to the corresponding rise of China and an expanding European Union during this period.

Relative Momentum First or Absolute Momentum First: Japan

Sources: TheRichMoose.com, MSCI Inc., FRED

Japan provides us with a stress test example of a highly diversified, high impact market going through a period where local stocks performed poorly while International stocks did extremely well.

To perform this test, I used the MSCI Japan Index, MSCI Kokusai Index, the MSCI ACWI ex-Japan Index, and Japanese CD data from the Federal Reserve Bank of St. Louis. All momentum evaluations used a 12-month lookback period and all data was priced in Japanese yen.

In this simple backtest, we can clearly see the many periods where Japanese stocks were underperforming CDs. This would put the investor into local bonds when absolute momentum was evaluated first (Gary's method). The investor missed years of International stock market exposure.

However, when doing a relative momentum evaluation first (my method), the investor was able to participate in International stock growth while the local market was underperforming.

In the end, an investor testing the absolute momentum of local stocks first would have realized a reasonable +8.03 percent compound annual return. The same investor testing relative momentum first would have realized a +10.46 percent compound annual return.

As seen by the chart below, the performance advantage for testing relative momentum first was noticeable across most time periods.

Sources: TheRichMoose.com, MSCI Inc., FRED

I acknowledge Japan might be a bit of an anomaly as an enormously inflated stock market going into the late-1980s. However, it does show us a recent example using a very diversified market, one that has a meaningful impact on the global economy, and a country with reserve status currency.

Conclusion

As long as the U.S. economy is the world's leading economy and the U.S. dollar is the base currency for global currency valuations and global economic activity, the method of testing absolute momentum first in the Dual Momentum model should work.

While U.S. stocks and the U.S. economy have performed well this past century and have been a leading indicator of the global economy, this phenomenon is likely to subside as the U.S. declines in relative impact. Just as the U.S. rose to prominence in the early 20th century, China and India are rising today.

Gary's method of evaluating Dual Momentum relies on the performance of U.S. stocks to get exposure to any equities. This limitation in the process needlessly exposes investors to single market risk.

Single market risk is very real. We can see the negative effects of a single market on Dual Momentum when we apply Gary Antonacci's process to Japanese stocks. Although Japan is not the U.S., it is also not a fringe economy with a non-influential currency or small global impact.

Given the shifts we are seeing today, it is not out of the realm of possibility that the U.S. experiences a similar decline in market influence, becoming a market laggard instead of a market leader.

We can significantly reduce our single market risk by slightly changing the Dual Momentum process. Instead of testing absolute momentum on U.S. stocks first, we should start with a relative momentum evaluation on our equity assets. We will still always test for absolute momentum on the better performing equity asset to ensure we are not investing into a declining market.

Comments & Questions

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A Better Look at Dual Momentum Fragility

Several weeks ago Corey Hoffstein of Newfound Research raised some important questions about the fragility of 12-month Dual Momentum (GEM) shared by Gary Antonacci. Gary responded in kind and it sparked a debate about 12M Dual Momentum and some related issues.

One of Corey's main arguments is that Dual Momentum, when measured only with a 12M lookback period, carries inherent and avoidable fragility. He notes that the model results vary meaningfully just by changing a single metric such as the number of months in the lookback period.

Corey suggests that investors can reduce risk by effectively tranching their Dual Momentum portfolio into multiple portfolios (he tests a model with 7 tranches) where each tranche invests in Dual Momentum following a different lookback period (6M through 12M). The tranches would be re-balanced each month to ensure equal impact of each lookback period.

This then led the debate to the next stage: setting aside Dual Momentum's recent signals, is there some reason to believe that the 12M lookback period is better than other periods (8M, 11M, etc.) to the extent that we should use it exclusively?

Is a 12-Month Lookback Better?

Gary argues essentially that 12M is better. It shows the best overall performance results for stocks, and this seems to be confirmed by academic evaluations going back a century or more. However, despite all the research, could this outperformance be a fluke?

I encourage you to read Gary's post which I linked above to understand some of the academic support behind the 12M lookback. This idea warrants a logical evaluation, especially how it relates to a self-directed investor implementing a Dual Momentum strategy for their retirement savings.

For the purposes of this argument, I will focus on the longer term lookback periods: 6M to 12M. While the shorter periods may have their own merits, they do require a lot more trading activity which I believe many self-directed investors would prefer to avoid.

First, although the 12M period does look really effective across the stock universe, I think it is somewhat speculative to say that 12M is the best. Lets look at some measures to test this.

Drawdowns

Sources: TheRichMoose.com, MSCI Inc., FRED

Looking at the drawdowns since 1970, it is hard to say that one lookback period is better or safer than the other. The 12M model has the largest absolute drawdown; however, the 6M spends more time in drawdown and comes very close the 12M model's biggest drawdown.

Both models share quite similar drawdown characteristics. They are highly correlated with the periods in drawdown showing significant overlap. When the 6M is in a drawdown, the 12M is also in a drawdown 86 percent of the time. Likewise, when the 12M is in drawdown, the 6M is also in drawdown 90 percent of the time.

However, although strongly correlated, they are certainly not precisely aligned. If I had to lend a preference to a lookback period based on drawdowns only, I would probably give a slight edge to 6M.

Returns

Sources: TheRichMoose.com, MSCI Inc., FRED

Looking at returns since 1970, we see the 12M system doing better overall. However, this is primarily due to lackluster performance in the 6M system in the late-1980s into the mid-1990s. Prior to, and following this period, 6M ran very close to 12M on an annualized rolling return basis.

Sources: TheRichMoose.com, MSCI Inc., FRED

Looking at the annualized 5-year rolling returns of each lookback period tested, we can clearly see the drop in the 1980s and 1990s for the 6M system. However, the chart also shows the systems performing quite comparably in the other market periods.

In fact, the two systems are 87.78 percent correlated on a monthly return basis over the period of 1970 through 2018. Despite the differences in end return, the monthly returns are very similar.

I think it is reasonable to assume that there may be some point in the future where 12M will underperform 6M by a reasonable margin for some time. After all, we do have limited data to work with and the returns observed for each system are within the historical ranges for the other system.

Sharpe Ratios

The Sharpe ratio is a common measure of portfolio performance factoring in risk. In this measurement, risk is measured via standard deviation which has its drawbacks—particularly when Dual Momentum has downside guards in place.

By this I mean, standard deviation measures return variance to the upside and downside as equals. However, in 6M and 12M Dual Momentum, downside is observed to a peak of -25 percent while upside goes over 60 percent in similar time frames. As investors, we like large upside movements, but would like to avoid large downside movements—a return stream Dual Momentum seems to provide.

These quirks aside, Sharpe ratios are still a useful rough measure to test risk-adjusted portfolio performance. In the 6M system, the Sharpe ratio is 0.733; in the 12M system, the Sharpe ratio is 0.874. The 12M system has a higher Sharpe ratio, so 12M is better lookback period by this measure.

What's more, the Sharpe ratio advantage for the 12M system seems to be pervasive throughout our lookback period. Even when we strip out 6M's diverging years (1988-1993), the 12M system still has a better Sharpe ratio at 0.841 compared with 6M's Sharpe of 0.815. (Although this difference is much smaller and I would consider them to be statistically "about equal".)

Newfound's 7 Period System

Next, we will take a closer look at Newfound's suggested system where the investor uses seven lookback periods to scale into and out of positions. Each system is re-balanced monthly as needed when trades are made; the impact of each system on the overall portfolio stays the same.

Setting aside trading frequency and cost for the moment, I have to say that Newfound's system does make logical sense. If the seven lookback periods have comparable expected long-term risk-adjusted returns, and if there are moderate differences between lookback periods, it should make a lot of sense for investors to spread their bets across a number of lookback periods.

In this way, each lookback period will have just 1/7th the impact on their total portfolio, but combined will still produce results very in line with a typical Dual Momentum investor's expectations. It would also help an investor avoid the effects of one underperforming lookback period in a given time frame.

Drawdowns

Sources: TheRichMoose.com, MSCI Inc., FRED

In this backtest, the Newfound 7 system is clearly better than the traditional 12M system in avoiding large drawdowns. Newfound 7's total maximum drawdown is -19 percent while 12M plunges lower at -25 percent.

The drawdowns are also more correlated. When Newfound 7's system is in drawdown, 12M is also in drawdown 92.4 percent of the time. Likewise, when 12M is in drawdown, Newfound 7 is in drawdown 94 percent of the time.

Over the entire testing period, Newfound 7 is in a drawdown slightly more often at 58.2 percent of months compared with 12M's 57.1 percent of months. However, this difference is clearly negligible.

Returns

Sources: TheRichMoose.com, MSCI Inc., FRED

When comparing the two models, again the 12M system does slightly better overall. 12M returns +16.1 percent compounded annually while the Newfound 7 system returns +15.5 percent compounded annually. Once again, the divergence comes primarily from the period around 1990.

Sources: TheRichMoose.com, MSCI Inc., FRED

The rolling annualized returns shown in this chart are indicative of how closely correlated Dual Momentum is—especially in the longer lookback periods. These two systems' monthly returns are 96.0 percent correlated across this test period.

While we see the familiar divergence in returns in the late-1980s and early-1990s, for the rest of the test period the returns are very tight with few meaningful divergences. It is a fair statement to say the overall performance for the two systems are extremely comparable.

However, the 12M system line (green) is noticeably above the Newfound 7 system line (blue) almost all the time.

Sharpe Ratios

When we compare the two system's average annual returns, the 12M system is better than the Newfound 7. This is naturally reflected in the higher overall returns we see with the 12M system. What surprised me is that the Newfound 7 system had a higher standard deviation.

This ultimately translated to the 12M system boasting the Sharpe ratio of 0.874 as shared previously. The Newfound 7 system was somewhat lower at 0.818.

Conclusion

What stood out most for me in doing this backtest is the robustness of Dual Momentum as a system, regardless of the precise lookback period used. The performance is truly outstanding with very admirable downside protection. Critique is absolutely fair, but Gary Antonacci deserves a lot of credit for sharing this with the public.

While I could have made an extremely long post comparing each lookback period from 1-month through 12-months with cluttered charts and graphs, I think the tests shared here are an adequate representation of how Dual Momentum performs on the longer side of the academically reviewed time-series momentum tests. I could quickly show more if need be.

On lookback periods, I think the evidence is pretty clear. For some reason, the 12-month lookback does perform better than shorter lookback periods including the 6-month. A 12-month lookback might not be better on every measure in every time period, but it's certainly an excellent option over full market cycles for self-directed investors.

When comparing 12-month DM to Newfound's 7 Period DM, I think Corey Hoffstein raised some important points. Scaling into and out of positions would have significantly reduced the maximum drawdown and also reduced the severity of most other drawdowns.

However, the important question is: Should a typical investor follow Newfound's suggested system to reduce risk in their portfolio?

Overall, I would say there are limited benefits to choosing Newfound's more complex system and there are some drawbacks.

First, we can't ignore that the two systems are extremely correlated at 96.0 percent. The difference in return stream offered by Newfound's system is very minimal. This is not a great way to diversify your portfolio. For perspective, U.S. stocks and International stocks only exhibit 70 percent correlation.

Second, the Newfound system would require significantly more trades. While I didn't count the trades for each system, a 6-month lookback trades twice as much as a 12-month lookback. Although trading costs are low, this is not insignificant. The true costs get higher for U.S. investors when considering short-term capital gains taxes in a non-registered investment account.

Third, the Newfound system does underperform the 12-month system on an absolute and risk-adjusted basis. While we may not be able to explain exactly why, a 12-month lookback period for broad stock indices has done extremely well. The higher Sharpe ratio, driven both by higher absolute returns and a lower standard deviation does not appear mere coincidence. The 12-month system stands above other lookback periods almost all the time. When it does underperform, it is not by much.

For a self-directed investor who has moderately sized retirement accounts, the best way to deal with the fragility of Dual Momentum is by adding a completely different non-correlated investment style as a significant component of your portfolio.

For example, a long-short strategy, managed futures, a tail-risk strategy, or an options trading strategy may nicely complement Dual Momentum. (I should point out this is precisely what I do in my personal portfolio, so take this with an ounce of bias.)

If a self-directed investor grows their personal accounts to a substantial size, there are some benefits to introducing additional lookback periods into the Dual Momentum portfolio of their portfolio. As this backtest demonstrates, additional lookback periods are likely to reduce overall drawdowns.

However, seven periods might be a bit extreme for any investor. For example, a quick test shows comparable downside mitigation with just four periods (6-month, 8-month, 10-month, and 12-month).

There are other considerations. An investor with large accounts is likely more interested in preserving capital (avoiding big drawdowns) than growing wealth. Multiple lookback periods as part of a trading system can be quite beneficial when this is the investor's focus.

A professional fund manager offering a Dual Momentum style fund to wealthy clients is likely to benefit the most from introducing multiple lookback periods. Professional managers get penalized heavily for drawdowns (fee revenue loss and client withdrawals), their clients are likely to have other funds in their portfolio for adequate diversification, and they have to make regular small trades in their course of business to account for distributions and fund flows.

In conclusion, no investor with even moderate wealth should put all of their money into a single investment model. Models can look great in backtests and may even perform very well going forward; however, we cannot predict that 12M Dual Momentum will provide 5-year rolling annualized returns between 3 percent and 45 percent going forward. It could be better, it could be worse.

While momentum-based strategies like Dual Momentum can provide a reasonable guideline for investing that is preferable to blindly holding the index, it does not guarantee protection from sudden drawdowns that could significantly exceed past events.

The best we can do is follow a sound premise, diversify across assets and strategies as needed based on our portfolio size and risk tolerance, and be prepared to invest counter to our emotional desires in the moment. The moment we override our strategy is the moment we no longer have a strategy. That is the real danger.

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.