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On Monday, I authored the first in a monthly series of articles on momentum strategies; demonstrating that monthly switching between various fixed income asset classes can allow investors to tailor their credit and interest rate exposure and generate sustainable and repeatable alpha over long time intervals. Today's article focuses on switching strategies between bonds and various classes of the equity market.

The purpose of this new series of articles is to demonstrate the success of these strategies, and give Seeking Alpha readers with differing risk tolerances tips on how to employ these strategies themselves to improve the performance of their balanced portfolio. These are useful strategies for Seeking Alpha readers, especially those who allocate dollars to their investment plan on a subscription basis like 401k investors making automatic payroll deductions. These switching strategies can be used to adjust periodic allocations to capture the momentum effect and improve portfolio returns, especially in tax-deferred accounts.

Treasuries/S&P 500

The most basic momentum strategy involving the equity markets and fixed income is between the benchmark Treasury index and the S&P 500 (NYSEARCA:SPY). The monthly strategy switches between the two asset classes, owning the asset class that performed the best in the trailing one month forward for the next one month.

In difficult market environments, Treasury bonds typically rise in value as a flight-to-quality instrument while risky assets sell off. In improving economic environments, the opposite is usually true as equities rally and bonds sell-off as investors reap the returns of equity ownership and Treasury bonds are negatively impacted by rising inflationary impacts.

Below is a graph of the historical performance of the S&P 500, the Barclays Capital Treasury Index (NYSEARCA:GOVT), and a momentum strategy that buys the asset class that had outperformed in the trailing one month.

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The results above should prove interesting to any Seeking Alpha reader trying to balance their allocation between stocks and bonds. Since 1973, when the Barclays Treasury index was first published, the momentum strategy has generated 90bps of annual outperformance versus the S&P 500 while only exhibiting roughly 2/3 of the volatility. Below is a graph of the risk/return profile of buy-and-hold portfolios of stocks and bonds versus this momentum portfolio historically.

This switching strategy would have allocated to stocks just over 55% (266/480 months) of the time from 1973-2012. Instead of allocating funds in a traditional 60% stocks/40% bonds balanced portfolio, allocating to the asset class that had outperformed in the trailing one month would have seen less dollars flow to equities, but roughly 130bps of average annual excess returns.

(click to enlarge) Of course, while this forty year time interval is a significant sample period, it overlaps with a historically good run for Treasury bonds as yields remain today near historic lows. Seeking Alpha readers may desire to substitute in higher yielding asset classes as part of their fixed income rotation. Substituting in investment grade or high yield corporate bonds has not historically generated incremental alpha because of the higher correlation between credit and equities.

Since 1973, a switching strategy between investment grade corporate bonds and the S&P 500 would have produced a 9.65% average annual return with an 11.56% annualized standard deviation of returns. This return profile had both lower average returns and higher risk than the Treasury/S&P 500 switching strategy, and marginally underperformed owning equities outright, albeit with just 74% of the volatility. A switching strategy between high yield corporate bonds and the S&P 500 from mid-1983 to current created zero alpha. The momentum portfolio would have had a return profile equivalent to owning 77% stocks and being in 23% cash earning zero, effectively a de-levered equity profile.

The low correlation between stocks and Treasury bonds (r = 0.10) as compared to IG bonds and stocks (r=0.34) and HY bonds and stocks (r = 0.58) is what drove the relative outperformance of the switching strategy utilizing Treasuries. Whether the U.S. Treasury is able to keep its status as a safe haven during market turmoil will affect the efficacy of this switching strategy prospectively. In coming months, I will only provide detail on the historically superior Treasury/equity switching strategy, but wanted to give a detailed reasoning behind this choice of Treasuries over higher yielding fixed income asset classes to readers.

Readers wishing to implement this switching strategy in their own portfolio would own the S&P 500 in January 2013 given the outperformance versus Treasuries in December 2012.

Treasury Bonds/Small-Cap Domestic Stocks

If the increased correlation between corporate credit and equities lowered returns relative to the Treasury/S&P 500 momentum strategy than it stands to reason that substituting a lower correlation, higher expected return equity asset class in the place of the S&P 500 in the switching strategy should generate even greater alpha. Using data back to 1979 from the Russell 2000 small cap stock market index (NYSEARCA:IWM), this superior return profile is graphed and detailed below.

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(click to enlarge)

Sometimes a picture is worth a thousand words. From 1979-2012, investors who employed a monthly switching strategy between small cap stocks and Treasury bonds would have cumulatively ended the period with nearly twice as much money as those who held the S&P 500. Over that time period, the switching strategy between small caps would have also had slightly less variability of returns than owning the broad equity market index outright. The Treasury index and Russell 2000 had slightly negative correlation between their return profiles over this time period (r= -0.01). Readers should take note that the Treasury/small cap switching strategy is a souped up version of the Treasury/large cap switching strategy with 300bps of incremental average annual excess returns, but 370bps of incremental annualized volatility.

Readers wishing to implement this switching strategy in their own portfolio would own the Russell 2000 in January 2013 given the outperformance versus Treasuries in December 2012.

Treasury Bonds/Emerging Market Stocks

If substituting small caps for the S&P 500 further enhanced the risk/return profile of the momentum strategy, then moving into emerging markets should further increase both risk and expected return. With data from the MSCI Emerging Market Index (replicated through VWO) from 1989-2012, an enhanced momentum strategy is exactly what substituting emerging markets has historically produced.

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(click to enlarge)

Emerging market stocks have been the most negatively correlated with Treasuries of the aforementioned equity asset classes (r=-0.17). EM stocks tremendous performance in the mid-2000s, which featured annual returns of at least 22% from 2003-2007, handed off nicely to the Treasury outperformance during the credit crisis. In the last ten years, this switching strategy has beat the S&P 500 by over 5.5% per annum with similar volatility. Over the totality of the dataset, EM stocks have been a high beta function of the developed world, and this momentum strategy has generated tremendous returns rotating towards the hot market during rallies and towards the safe haven of Treasuries during bear markets.

Readers wishing to implement this switching strategy in their own portfolio would own emerging market stocks in January 2013 given the outperformance versus Treasuries in December 2012.

Summary

For Seeking Alpha readers interested in gleaning long-term alpha through momentum, I will be updating the performance of these three trades (Treasuries/S&P500, Treasuries/Russell 2000, Treasuries/EM Stocks at the end of each month. By providing performance over the trailing one month, momentum investors can follow along with these trades in their own portfolios. Please check out my aforementioned article on fixed income momentum strategies, and look for a coming article on momentum trades within the equity universe that will also be updated monthly.

Source: Equity/Fixed Income Momentum Strategies - January 2013