Dual Momentum – The Famous 5 Portfolio

This article describes a Dual Momentum study over a multi-asset ETFs basket with a new attempt to improve this well-known investing style.

Dual Momentum strategies rely on two different very simple filters: absolute momentum and relative momentum.

Absolute momentum (rule 1) is a trend following filter used to switch any selected assets that have a negative excess return over the risk-free rate to cash while relative momentum (rule 2) criteria compares returns of a basket different assets through a ranking list to highlight those assets with the highest return.

I considered a time window of three months in my backtest, as it has shown the strongest results.

Rule 1: If the asset shows that the last three months return is higher than the risk-free rate then buy or keep the asset, if not just switch to cash.

Rule 2: Buy or keep the # assets with the highest three months return if Rule 1 is satisfied, otherwise just move or stay in cash.

I backtested the following portfolio of multi-assets ETFs going back to January 2006 and holding each time the two assets with the highest three months return (holding 2 assets instead of 1 improves the results). I considered the five most common stocks ETFs:

GLDSPDR Gold Shares ETF
VOVanguard Mid-Cap ETF
VBVanguard Small-Cap ETF
VTIVanguard Total Stock Market ETF
QQQPowerShares QQQ Trust ETF
SPYSPDR S&P 500 ETF
TLTiShares Barclays 20 Year Treasury Bond Fund ETF

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PortfolioInitial BalanceFinal BalanceCAGRStd.Dev.Best YearWorst yearMax.
Drawndown
Timing Portfolio$10,000$54,48518.99%12.98%37.74%-7.01%-14.90%
Equal Weight
Portfolio
$10,000$23,3569.09%12.02%27.03%-22.06%-33.70%

Applying Dual Momentum strategy more doubles the Final Balance and CAGR and cut by half Max Drawdown of the Equal Weight Portfolio.

This improvement from the Equal Weight Portfolio can be clearly seen on the equity curve too:

Equal Weight Portfolio. Dual momentum

Sitting on cash while out of the market can obviously be a waste of time, and good results can be achieved simply by switching to SHY (iShares Barclays 1-3 Year Treasury Bond Fund) instead of cash.

Hereafter, the new performance metrics:

PortfolioInitial
Balance
Final
Balance
CAGRStd.Dev.Best yearWorst yearMax.
Drawdown
Timing Portfolio$10,000$56,07519.34%12.99%37.74%-6.74%-14.67%

GAGR is above 19% and maximum drawdown has been reduced below 15%. Equity curve follows:

drawdown below 15%. Equity curve. Dual momentum

Adding a safe instrument of the monetary market helped both rising return and cutting risk. I considered it “safe” due to the next multi-year coming Fed rising rates environment. With the duration limited to a maximum of three years, new higher rates can easily be exploited.

Of course, nothing can be taken for granted and that is why until Fed does not start the rising rates process another adjustment should be implemented to the Dual Momentum Countries Portfolio: using TLT (iShares Barclays 20 Year Treasury Bond Fund) instead of SHY. Results are the followings:

PortfolioInitial
Balance
Final
Balance
CAGRStd.Dev.Best yearWorst yearMax.
Drawdown
Timing Portfolio$10,000$67,34321.61%13.78%37.74%-5.18%-14.02%

GAGR rised well above 20%.

GAGR rised well above 20%. Dual momentum

To sum up, adding long term treasuries (TLT) might be perceived as an additional risk factor due to the coming Fed restrictive monetary policy, but as far as this has not occurred yet, a portfolio with a growth rate higher than 20% looks very attractive to investors.

The overall strategy performance should turn in favor of the short term treasuries (SHY) option as soon as rates begin to rise, in contrast to the last 15 years decreasing rates/zero rates/quantitative easings financial environment that led TLT-based strategy to higher returns.

That is why I shall expect a 20% returns range for the SHY-based strategy and a lower one for the TLT-based one in the coming years once rates start rising.

–By Marco Simioni of  Nightly Patterns

About the Author Marco Simioni

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