Thanks for reading the fourth installment of equity/fixed income momentum strategies. This article discusses the historic return profile of momentum strategies between fixed income and equity classes, and gives an overview of the reasons behind last month's relative performance and a look forward to relative returns in April. The momentum strategies' relative returns in February successfully predicted the leg that would outperform in each of the three trades in 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 (NYSEARCA:GOVT) and the S&P 500 (NYSEARCA: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 86ps 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 March 2013, given the outperformance versus Treasuries (S&P 500 1.36% vs. Treasuries 0.53%) in February. Subscribers to this momentum theory (and articles) would have been handsomely rewarded in March as the S&P 500 outperformed Treasuries by 365bps. This outperformance suggests that investors should want to own the S&P 500 relative to Treasuries in April as well. The momentum trade between Treasuries and the S&P 500 would have kept investors in equities in all four months so far in 2013, generating outperformance in each period thus far.
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. In my February 2013 article, "The Small Cap Stock Index For You," I demonstrated that the S&P Smallcap 600 (NYSEARCA:IJR) is a preferable index to the Russell 2000, but use the latter index here for its long historical track record.
Readers wishing to implement this switching strategy in their own portfolio would have owned the Russell 2000 in March 2013 given the massive 57bp outperformance versus Treasuries in January 2013 (1.1% vs. 0.53%). An investor implementing this strategy would again have been rewarded in March as small-cap stocks bested Treasuries by a healthy 452bps. This relative outperformance in March signals that small-cap stocks' relative outperformance is likely to extend into April 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 4.1% 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 17.1% 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 6.9% 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 Treasuries in March 2013, given the underperformance of EM stocks versus Treasuries in February (-1.3% vs. 0.53%). The emerging market leg of this trade underperformed in February, suggesting that momentum investors would favor Treasuries in March, an indicator that proved to be prescient. Emerging market stocks continue to lag domestic stocks given the emerging world's higher weight towards lagging materials and commodities stocks and heightened geopolitical risk in large emerging market, South Korea (down 1.7%). The most oft cited emerging market index has now trailed the S&P 500 by 14% over the last twelve months as exporters have been hampered by a weak European economy and concerns over a hard landing in China depressed values. March's underperformance by emerging market stocks would suggest that investors continue to own Treasuries over emerging market stocks in April.
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 tomorrow.
Disclosure: I am long SPY, VWO. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.