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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 published an article on three stock/bond momentum strategies that have produced long-run alpha. Each of the strategies detailed in that article outperformed in October, and both of the strategies in this article also chose the outperforming leg of the trade last month.

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 (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 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:

(click to enlarge) (click to enlarge)

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 in November given their outperformance in October. Staying with high beta stocks last month allowed investors subscribing to this momentum strategy to 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. It should be noted however that low volatility stocks as an asset class have had only slightly lower variability of returns than high beta stocks (see the year-to-date standard deviation of monthly returns in the table). The impact of quantitative easing has led to high pairwise correlation between index constituents, but low volatility stocks, which were driven higher by investors seeking stable equities amidst anemic yields in fixed income, have been more negatively impacted by the move higher in interest rates. This rate-sensitivity has driven a higher asset class volatility relative to the lower quality, high beta stocks.

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 ten years, the beta of the emerging market stock index (relative to the S&P 500) has been 1.29. 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 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. Emerging market stocks have now outperformed U.S. equities for three straight months. This momentum strategy has captured the 11.4% return for emerging market equities over the last two months, the highest two month return for the asset class since the fourth quarter of 2010.

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. This helps to explain the strong returns in the past two months for emerging market equities. As the Federal Reserve chose not to "taper," interest rates moved modestly lower in the United States, reducing capital flow pressures in the emerging world. Emerging market asset classes will remain under pressure due to the volatility of monetary policies in the United States. The momentum strategy suggests that emerging markets will continue to outperform in November.

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.

This momentum strategy has outperformed the emerging market stock index on both an absolute and risk-adjusted basis over long-time intervals. If emerging market stocks are going to be 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. For the third 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 November. 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. As always, input from my strong readership can help improve this content as we "Seek Alpha" together.

Source: Stock Momentum - November 2013