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Last week we explored a simple dual momentum strategy using three portfolios consisting of three mutual funds. The strategy was inspired in part by Gary Antonacci's "Risk Premia Harvesting Through Dual Momentum" paper available on Optimal Momentum.

The first article generated interest and several readers emailed questions. To reiterate, mutual fund were used strictly because of their longer trading histories. Since most mutual funds have trading restrictions, a real-world application of the strategy would be better served with exchange-traded funds (ETFs) that do not have many of the same trading restrictions. However, with ETFs come commissions, which will reduce overall returns.

The portfolios in the first article were not meant as optimal portfolios but there was a rationale behind the security selection. Funds were grouped into three asset classes - equities, bonds, and real assets - that historically perform differently in different economic conditions. Within each asset class, two funds were selected that have historically low correlations, although there have been extended periods of time where U.S. and emerging equities, for example, have been highly correlated.

The results from the first article were impressive when tested from 2003-present. However, results over the past two years have been more tempered. The recent returns are one example of why it is important not to rely on one test, portfolio, or time-frame to draw broad-based conclusions.

What happens if we modify the portfolio holdings? Does the dual momentum strategy hold up well? Also, what if we just equally weight the portfolio and re-balance annually? Does the dual momentum strategy still outperform? I attempt to answer those questions in the tables below.

The strategy for the backtests involves purchasing one mutual fund in each portfolio and equal weighting the three portfolios to create a "complete" portfolio. Purchases are determined by the one fund in each portfolio which has the highest trailing 6 month returns. The strategy rebalances each month, selling the current holding if it is no longer the top ranked fund in its portfolio and replacing it with the fund which has the highest momentum.

You will notice a short-term Treasury fund is in each portfolio. Combining absolute and relative momentum means a mutual fund outperforms a risk-free asset class such as cash in addition to outperforming all of the other asset classes in the portfolio. Thus, for the purposes of this test I added a short-term Treasury fund to each portfolio to represent a risk-free asset and to act as a comparison point for absolute momentum.

Portfolio #1 consists of the same securities as my first article:

Portfolio #1
Equity BasketSymbol
Emerging MarketVEIEX
U.S. Total Stock MarketVTSMX
Short-Term TreasuryVFISX
Bond Basket
Emerging Market BondPREMX
Long-Term Investment Grade U.S.VWESX
Short-Term TreasuryVFISX
Real Asset Basket
Precious Metals & MiningVGPMX
MSCI REITVGSIX
Short Term TreasuryVFISX

Portfolio #2 consists of the following securities:

Portfolio #2
Equity BasketSymbol
Emerging MarketVEIEX
US Total Stock MarketVTSMX
Short Term TreasuryVFISX
Bond Basket
Emerging Market BondPREMX
Long-Term Investment Grade USVWESX
Short-Term TreasuryVFISX
Real Asset Basket
GSCI IndexGTY
MSCI REITVGSIX
Short-Term TreasuryVFISX

Portfolio #3 consists of the following securities:

Portfolio #3
Equity BasketSymbol
Total International StockVGTSX
U.S. Total Stock MarketVTSMX
Short-Term TreasuryVFISX
Bond Basket
Emerging Market BondPREMX
Long-Term Investment Grade U.S.VWESX
Short-Term TreasuryVFISX
Real Asset Basket
GSCI IndexGTY
MSCI REITVGSIX
Short-Term TreasuryVFISX

The returns for the different portfolios and different strategies are in the next table. The time-frame for the tests is 2003-December 21st, 2012. Two benchmarks have been added, a 60/40 Balanced Vanguard Fund (MUTF:VBINX) and the SPDR S&P 500 Index ETF (NYSEARCA:SPY).

The equally weighted portfolios all have seven positions weighted at 14.285% and include one position in the Vanguard Short-Term Treasury Mutual Fund (MUTF:VFISX). The equally-weighted portfolios include results with an annual rebalance of each position back to 14.285%.

In each case, the dual momentum strategy still outperforms on an absolute and risk-adjusted basis, its equally-weighted portfolio and the benchmarks. All test results courtesy of ETFReplay.com:

StrategyTotal ReturnCAGRSharpeVolatilityMax Drawdown
Portfolio #1 Dual Momentum Strategy398.50%17.50%1.0912.80%-18.50%
Portfolio #1 Equally Weighted, Annual Rebalance196.30%11.50%0.6613.60%-42.02%
Portfolio #2 Dual Momentum Strategy357.30%16.50%1.1411.50%-13.40%
Portfolio #2 Equally Weighted, Annual Rebalance153.10%9.80%0.6111.60%-40.94%
Portfolio #3 Dual Momentum Strategy320.20%15.50%1.1210.90%-13.10%
Portfolio #3 Equally Weighted, Annual Rebalance126.20%8.50%0.5311.40%-40.79%
60/40 (VBINX)98.20%7.10%0.3912.20%-35.97%
SPY97.20%7.10%0.320.70%-55.20%
Source: Dual Momentum Investing