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Each month, I am authoring articles updating the performance of monthly momentum strategies across a host of asset classes with this being the fourth monthly installment. On Tuesday, I published an article on fixed income momentum strategies, and yesterday an article was released on equity/fixed income momentum switching strategies. This is the third article in this series to be updated at the beginning of each month, and will be focused on momentum strategies within the equity universe. Yesterday's article demonstrated that momentum successfully chose the outperforming leg in all three of the trades detailed. In the two equity momentum strategies depicted in this article, the outperforming leg in February continued to outperform in March.

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 respective 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. Even if readers are uninterested in implementing a momentum strategy in their own portfolio, given the long and successful track record of these strategies, these articles can still help Seeking Alpha readers time short-term tactical asset allocation decisions.

Low Volatility Stocks/High Beta Stocks

In my mid-January article "Doubling the Return of the S&P 500 Over Twenty Years," I demonstrated that a quarterly switching strategy between low volatility stocks, as represented by the S&P 500 Low Volatility Index (SPLV), and high beta stocks, as represented by the S&P 500 High Beta Index (SPHB), generated a cumulative total return more than double that of the S&P 500 (SPY) since 1990 with a risk profile equivalent to that of Berkshire Hathaway (BRK.A, BRK.B). In this series, I will update a monthly switching strategy that will effectively own the highest or lowest volatility equities in the S&P 500 based on which segment of the market had outperformed in the trailing month.

A monthly switching strategy between low volatility and high beta stocks, which buys the leg that outperformed over the trailing one month and holds that leg forward for one month, has produced the return profile seen below since 1990:

(click to enlarge)

(click to enlarge)

Despite the broad market rally in February, the High Beta Index actually lagged Low Volatility stocks in February (LV: 2.72%; HB -1.53%). This February return profile suggested that low volatility stocks should be owned in March relative to their riskier counterparts. This transition to lower volatility stocks proved to be a winner in March as the Low Volatility Index outperformed High Beta stocks by 171bps (4.87% vs. 3.16%). High beta stocks have now underperformed the S&P 500 for consecutive months. Year-to-date, this momentum strategy has earned 11.3% through March, outpacing the S&P 500 by 69bps, despite owning High Beta stocks in February when they lagged. The excess returns to owning high beta stocks in January and low volatility stocks in March has more than made up for last month's underperformance.

I am of the opinion that low volatility stocks should be a part of investors' longer-term strategic asset allocation given that class of stocks' historical higher average returns and lower variability of returns. Conversely, an allocation to high beta stocks must be done tactically with a short-term focus given that class of stocks' lower long run average returns and higher variability of returns. This view is borne out of the data above. Over one, three, five, ten, and twenty year trailing periods, low volatility stocks have outperformed high beta stocks on both an absolute and risk-adjusted basis. However, a temporary allocation to the High Beta Index in sharply rising markets can further boost performance as seen by the outperformance of the momentum strategy.

Over the last twelve months, the momentum strategy that switches between High Beta and Low Volatility stocks has nearly doubled the return of the S&P 500 (26.3% vs. 14%) while posting similar volatility. Over the past ten years, the strategy has produced an annual return of nearly 14%, which would rank the strategy amongst the top actively managed funds in the United States. Understanding the historical performance of this trade can help Seeking Alpha readers time their entry into riskier parts of the equity universe.

(click to enlarge)

(click to enlarge)

After February's negative return for emerging market stocks (-1.3%), stocks in the developing world again trailed the domestic market (-1.71% versus S&P 500's 3.75% return). The momentum strategy of course suggested owning the S&P 500 given last month's outperformance, and would suggest that domestic equities be owned again in April.

I believe that emerging market stocks (VWO and EEM replicates the benchmark used) will outperform the developed world over the intermediate to long term as higher economic growth rates and less constrained government balance sheets lead to higher asset returns. Over the last twelve months, domestic equities have strongly outperformed emerging market equities as accommodative monetary policy in the developed world has encouraged investors to move out the risk curve and also weakened DM currencies through lower interest rates, improving relative performance versus emerging market exporters. Perhaps this momentum strategy can key when to make a longer-term asset allocation shift to emerging market equities with higher expected long-run returns.

It should be noted that in all of the time horizons in the table above, the momentum strategy has outperformed the emerging market stock index on both an absolute and risk-adjusted basis. If emerging market stocks are a part of your asset allocation mix, then understanding this trade can help improve portfolio performance.

Summary

High quality domestic stocks continue to be the predominant source of excess returns in global equity markets. This article suggests that low volatility equities will outperform higher beta equities and domestic stocks will continue to outperform EM stocks again in April.

Switching strategies that tactically overweight high beta equities when markets are rising and seek safety in lower beta equities when markets are falling have traditionally produced higher risk-adjusted returns over long time intervals. I will be updating these two trades monthly, along with my companion series on fixed income and equity/fixed income momentum strategies. Expect to see a few additional equity momentum strategies evolve in this series over time, and as always input from my strong readership can help improve this content as we "Seek Alpha" together.

Source: Equity Momentum - April 2013