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Near the beginning of each month, I am authoring articles updating the performance of monthly momentum strategies across various markets. Earlier this month, I published articles on fixed income and equity/fixed income momentum 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. The switching strategy between the U.S. and emerging markets continued its strong performance in June, but the low volatility/high beta momentum trade failed to provide the correct signal as low volatility stocks rebounded relative to high beta stocks after their trouncing in May driven by the increase in interest rates.

The purpose of this series of articles is to demonstrate the long-run success of these strategies, and give Seeking Alpha readers with differing risk tolerance 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 (NYSEARCA:SPLV), and high beta stocks, as represented by the S&P 500 High Beta Index (NYSEARCA:SPHB), generated a cumulative total return more than double that of the S&P 500 (NYSEARCA:SPY) since 1990 with a risk profile equivalent to that of Berkshire Hathaway (BRK.A, BRK.B). In this series, I am updating 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 year-to-date, the High Beta Index had actually lagged Low Volatility stocks through the end of April (LV: 17.5%; HB 9.1%). At the end of the first half of 2013, the two different classes of domestic stocks had produced nearly identical 14.1% returns.

While high beta stocks had underperformed the S&P 500 for three consecutive months, they reversed their performance in May versus the broad market index (HB: 7.12%, S&P 500: 2.34%). Low volatility stocks were hurt by sharply higher interest rates, which saw money flow away from high dividend paying, more bond-like equity investments as the market began to price in an earlier end to the Federal Reserve's quantitative easing program. As I wrote in "The Historic Utility Selloff", utilities, which make up 30% of the Low Volatility Index, had their worst performance relative to the S&P 500 since the month before the Enron bankruptcy in 2001. Perhaps unsurprisingly, that month also marked the largest underperformance by low volatility equities relative to the S&P 500.

May's underperformance by low volatility stocks presaged a continued selloff in June, but we actually saw a moderation in the selloff with low volatility stocks outperforming high beta stocks and the broader market for the month. This signals that low volatility stocks will outperform again in July.

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. Over the near term, I expect that low volatility stocks will rebound given my expectation that the sharp move higher in interest rates will moderate and that we will not see a reduction in the level of quantitative easing before the end of 2013. However, I also made this observation last month, and Friday's payroll number and resultant backup in Treasury rates has again pressured low volatility stocks, which are more rate sensitive than their higher beta counterparts.

If an allocation to low volatility stocks should be part of your strategic asset allocation, then 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. Despite May's massive underperformance, over 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 past ten years, the strategy has produced an annual return of nearly 11.4%, 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 domestic large cap equity universe. In the short term, the momentum strategy would suggest that investors stick with high beta stocks given their outperformance in May. For investors seeking a tactical trading edge, this approach could add alpha. For investors examining low volatility stocks as part of a long-run portion of their strategic equity allocation, they may seek to add these stocks on the dip.

U.S. Stocks/EM Stocks

Similar to the decision whether to tactically overweight high beta stocks, investors can also decide whether to add exposure to emerging markets, which have effectively been a high beta function of the developed world historically. This relationship is borne out mathematically. The financial concept beta is calculated as the covariance between a stock and its benchmark divided by the variance of the benchmark. Over the trailing five years, the beta of the emerging market stock index (relative to the S&P 500) has been 1.26. Like our switching strategy between Low Volatility and High Beta stocks, a switching strategy between U.S. stocks and emerging market stocks should also produce alpha. That is exactly the return profile captured below:

(click to enlarge)

(click to enlarge)

The MSCI Emerging Market Index has trailed the S&P 500 in each of the first six months of the year, which means that this momentum strategy has kept investors in the outperforming domestic market. While the -2.94% return for emerging market stocks in May 2013 was the worst performance since the broad market selloff brought about by heightened European concerns in May 2012, June's -6.32% return marked the worst performance for the asset class since the fourth quarter of 2011. The outperformance of domestic stocks in June dictates that this momentum strategy will continue to own the S&P 500 in July as well. This losing streak by emerging market stocks is now the longest streak since the height of the financial crisis in late 2008.

I believe that emerging market stocks (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. I am currently evaluating the strength of this conviction, and whether to shift a portion my long-term strategic portfolio allocation into the battered emerging markets. Look for a coming article on this topic.

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

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. Investors should continue their focus on domestic stocks over emerging market stocks, and those seeking a short-term tactical edge should favor low volatility stocks domestically over the next one month. 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.

Disclosure: I am long SPY, SPLV. 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.

Source: Equity Momentum - July 2013