Thanks for reading the third installment of equity/fixed income momentum strategies. In this article, we will discuss the historic return profile of momentum strategies between fixed income and equity classes, and give an overview of the reasons behind last month's relative performance and look forward to March.
The purpose of this 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.
The most basic momentum strategy involving the equity and fixed income markets is between the benchmark Treasury index (GOVT) and the S&P 500 (SPY). This 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, and a momentum strategy that buys the asset class that had outperformed in the trailing one month.
Over trailing 1, 3, 5, 10, and 40 year time horizons, this momentum strategy has outperformed the S&P 500 with lower volatility. 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 87bps 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 with varying mixes 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 cumulatively generated roughly 130bps of average annual excess returns. Using the momentum approach to allocate funds, investors would have actually put less money into stocks over that forty-year period than investors using a 60%/40% stocks/bonds split. However, the momentum approach would have produced meaningful incremental returns with lower realized volatility.
(For a mathematical look at why Treasuries were chosen as the fixed income asset class in these equity/fixed income momentum strategies see my inaugural article on these strategies.)
Readers wishing to implement this S&P 500/Treasury switching strategy in their own portfolio would have owned the S&P 500 in February 2013, given the outperformance versus Treasuries (S&P 500 5.18% vs. Treasuries -0.81%) in January. Subscribers to this momentum theory (and articles) would have been modestly rewarded in February as the S&P 500 outperformed Treasuries by 83bps. This outperformance suggests that investors should want to own the S&P 500 relative to Treasuries in March as well.
Treasury Bonds/Small-Cap Domestic Stocks
The efficacy of these momentum strategies is driven by the low correlation between Treasuries and stocks as the two asset classes perform well in differing market environments. These strategies suggest that the market is slow to adjust to new information, allowing for outsized returns by following the trade that has been outperforming in short trailing periods (and maybe more importantly avoiding stocks, or risky assets generally, when markets are falling). It stands to reason that an asset class with an even lower correlation with the Treasury market historically, and higher long-run expected returns should produce a momentum strategy profile that fares even better than the aforementioned S&P 500/Treasury switching strategy. This is exactly what we find when small cap domestic stocks are incorporated.
From 1979-2012, investors who employed a monthly switching strategy between small-cap stocks (Russell 2000 ETF: IWM) and Treasury bonds would have cumulatively ended the period with nearly three times as much money as those who bought and 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 450bps of incremental average annual excess returns, but 400bps of incremental annualized volatility.
Readers wishing to implement this switching strategy in their own portfolio would have owned the Russell 2000 in February 2013 given the massive 707bp outperformance versus Treasuries in January 2013 (6.26% vs. -0.81%). An investor implementing this strategy would again have been modestly rewarded in February as small-cap stocks bested Treasuries by 57bps. This relative outperformance in February signals that small-cap stocks' relative outperformance is likely to extend into March as well.
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.
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 beaten the S&P 500 by over 4.3% 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.
Of course, the trailing twenty-five years have been historically strong for both emerging market stocks and U.S. Treasuries, which I believe we will look back on in future periods as a historic anomaly. While investors should not expect a 17.2% annualized return over the next twenty-five years, I believe that this switching strategy will continue to produce alpha. Even in the trailing five years as emerging market stocks produced a negative cumulative return, this momentum strategy managed a 5.8% annualized return, which would have outperformed the S&P 500 on both an absolute and risk-adjusted basis.
Readers wishing to implement this switching strategy in their own portfolio would have owned emerging market stocks in February 2013, given the outperformance versus Treasuries in January (1.31% vs. -0.81%). The emerging market leg of this trade actually underperformed in February, which would signal that momentum investors would favor Treasuries in March.
In my equity momentum series, one of the pair trades is between the S&P 500 and emerging market stocks. In the "risk-on" move in January, you would have expected emerging market stocks to beat domestic stocks, but that was not the case as the S&P 500 bested the EM index by 3.87%. Emerging market stocks continued their relative weak performance to domestic equities in February as weak economic data, earnings misses by index constituents, and concern over a surprising election outcome in Italy sparked renewed contagion fears in Europe, a chief market for EM exporters.
It should be noted that it appears that we are reaching an inflection point for following the momentum of riskier asset classes. While the S&P 500 outperformed Treasuries, small-cap stocks lagged their large-cap stocks, and emerging market stocks trailed Treasuries altogether. In my fixed income momentum series, high yield bonds also modestly trailed Treasuries, which may suggest that the "beta" trade we saw at the beginning of the year is fading.
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 an update of my equity momentum strategy early next week.