Near the beginning of each month, I am authoring a trio of articles updating the performance of monthly momentum strategies across various markets. Yesterday, I demonstrated the long run alpha available through momentum in various fixed income sectors. 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, easily besting the S&P 500 with lower return volatility:
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 (see 5, 10, 20 and lifetime returns above for low volatility stocks versus high beta stocks). In "Making Buffett's Alpha Your Own," I broke down the Oracle of Omaha's tremendous track record into two components - capturing the Low Volatility Anomaly and the application of leverage.
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. 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. The high beta stock index has typically outperformed in post-recession recoveries.
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. Low volatility stocks have been hampered recently by the move higher in interest rates, which has decreased the earnings yield premia from these stable companies. In the first six months of the year, low volatility stocks and high beta stocks had produced equivalent 14.1% returns, but high beta stocks have strongly outperformed in the back half of the year. In the short term, the momentum strategy would suggest that investors continue to own high beta stocks given their outperformance in September. Staying with high beta bonds last month allowed investors subscribing to this momentum strategy to strongly outperform.
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 if they are pressured again by a move higher in interest rates.
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:
The MSCI Emerging Market Index trailed the S&P 500 in each of the first seven months of the year, which means that this momentum strategy has kept investors in the outperforming domestic market since the end of January. The trade finally reversed in August with emerging market stocks producing a relative outperformance versus domestic equities. This outperformance in August suggested that emerging market stocks would outperform in September, and investors that subscribed to this theory were handsomely rewarded in September, the best return for the asset class since January 2012. Momentum followers would want to continue to overweight emerging market stocks relative to domestic equities in October.
Capital flows have dominated both emerging market fixed income and equity markets in 2013. As the market began to price in higher interest rates in the developed world, hot money that had flowed into emerging markets post-crisis began to rotate back to the U.S. and Europe, dampening asset prices in the developing world. Emerging market asset classes will remain under pressure due to the volatility of monetary (and newly fiscal) policies in the United States. While the momentum strategy suggests that emerging markets will continue to outperform in October, a prolonged government shutdown or a contentious debt ceiling debate could well disproportionately negatively affect the emerging markets as capital flows back to (for the moment) "flight to quality" markets.
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, albeit amidst slower economic growth than the leading emerging markets have experienced over the trailing decade. While geopolitical hotspots have cooled over the last month, risk flares on the Korean peninsula, Egypt, Turkey, Brazil, Iran, and most recently Syria have pressured global markets to some degree.
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 going to be a part of your asset allocation mix, then understanding this trade can help improve portfolio performance.
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. For the second month this year, emerging market stocks have outperformed domestic stocks over the trailing one month, which suggests that emerging market stocks could again outperform in October. Domestically, outperforming high beta stocks would also favor that higher risk leg over the short-run. 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 as I demonstrated with my recent Contrarian and Momentum Investing articles. 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.