In response to a reader question about whether substituting the equal weighted S&P 500 (RSP) in for the capitalization weighted S&P 500 (SPY) would produce higher average returns in my momentum strategies, I authored a piece entitled Combining Contrarian and Momentum Investing, demonstrating the efficacy of a strategy that marries equal-weighting and momentum. This is a promised follow-up piece demonstrating another strategy that combines these two seemingly opposite concepts to produce substantial long-run alpha.
For readers who read yesterday's article, this is a rehash of the theoretical underpinning behind the strategies, but is useful background for new readers. For repeat readers, see "Strategy" section below.
The reader's question likely emanated out of the fact that the contrarian nature of equal weighting (buying losers, selling winners) and the alpha generated by momentum (buying winners, selling losers) appears antithetical. The two systematic trading strategies both produce alpha, but over different holding periods. Momentum strategies outperform for periods ranging from just weeks to several months, while contrarian strategies work over longer holding periods.
This hand-off makes intuitive sense. If momentum strategies outperformed over longer time intervals, these stocks would become expensive relative to fundamentals and contrarian investors could sell these stocks short (or conversely buy stocks that have underperformed over long time periods) and earn excess returns over forward periods.
This intuitive juxtaposition of momentum and contrarian investing is supported by academic research. Value investing has been supported as a long-term wealth creator since the 1930s works of Benjamin Graham, former professor of Warren Buffett at Columbia Business School and author of the highly acclaimed "Security Analysis." Equal weighting is a form of value investing as the strategy necessarily buys stocks that have underperformed to return them to their equal weighting at the rebalancing date. Value investing strategies that purchase companies with comparatively low prices to trailing earnings (Dreman 1998) or low prices relative to book value (Fama and French 1992) to produce long-run outperformance have long frequented academic literature.
In my monthly series on equity/fixed income momentum strategies, I have demonstrated that a strategy that buys Treasuries (GOVT) or the S&P 500, based on which asset class had outperformed in the trailing one month, and holds that asset class forward for one additional month has generated meaningfully higher total returns over long time periods as detailed below.
Swapping the equal weighted S&P 500 (since the advent of the index in 1990) in for the capitalization weighted S&P 500 produces even greater outperformance.
Notice that the momentum strategy involving the equal weighted S&P 500 instead of the capitalization weighted S&P 500 produced higher average returns in each of the historical periods albeit with slightly higher risk. This risk, as measured by the annualized monthly standard deviation of total returns, is still much lower than the risk of a buy-and-hold equity portfolio due to the temporal allocation to lower volatility Treasuries. A 13.35% return with this type of volatility would have likely placed this strategy amongst the top fund managers in the world over this time period as the strategy bested the average return of the S&P 500 by 4.4% per year, with only three-quarters of the volatility.
Readers would be correct to point out that this strategy, while generating exceptional performance over the entirety of the sample period, trailed the S&P 500 in the 1990s on an absolute basis. This strategy still produced incremental returns when adjusted for its lower risk. As we know now in hindsight, the S&P 500 in the late 1990s, fueled by the tech-run, would materially underperform in the early 2000s. This momentum strategy outdistanced buy-and-hold equity portfolios by allocating to Treasuries in "risk-off" environments when "flight-to-quality" instruments like Treasuries outperformed substantially. Readers today might point out that this strategy could underperform prospectively as Treasuries produce negative total returns in forward periods, but the momentum aspect of this strategy would have kept investors in equal-weighted equities in 2013, which have continued to outperform. Balancing the benefits of momentum in short-term tactical asset allocation decisions with strategic long-term source of alpha (like contrarian or value investing) produces extraordinary results.
Some readers have pointed out that midcap funds have highly correlated returns with the equal-weighted S&P 500, and that certain mid-cap index funds with lower expense ratios might be preferable. I will demonstrate that equal weighting the S&P 500 is not simply a mid-cap proxy in a coming article. A midcap/Treasury momentum strategy would have produced alpha over this sample period. An equal-weighted midcap/Treasury momentum portfolio would have generated even more alpha.