ValidFi's  Instablog

Momentum effect, i.e. a phenomenon that past 'hot' funds or assets will continue to be 'hot' in a certain future period, has been widely recognized as a market inefficiency, both by practitioners and academic researchers. Momentum based  strategies have been proposed in equity (stocks), commodities and asset allocation investing (see this article for more information).

Less well known is that momentum effect exists even in boring and slowly moving fixed income (bonds) markets.  In a recent research paper titled 'Hot Hands' in Bond Funds by Derwall, Jeroen and Huij, Joop, it is shown that investing based on past performance momentum in bond funds could earn statistically significant returns. In practice, FundX's Janet Brown has a long running investment newsletter on a technique called 'Upgrading'. One of its model portfolios is based on selecting bond funds based on a momentum score. Utilizing such a method, FundX now manages a mutual fund FundX Flexible Income (INCMX).

We construct a model portfolio that selects a bond fund monthly or quarterly among a list of funds whose managers have won Morningstar's fixed income manager of the year award since 7//30/2000. In the back testing during the past 9 years, both monthly and quarterly based portfolios have achieved more than 10% annualized return. The following table compares the two portfolios performance (from 7/30/2000 to 10/10/2009):

	Up To Date	Last 5 Years	Last 3 Years	Last 1 Years
AR(%) (monthly portfolio)	11.46	9.806	10.462	23.226
AR(%) (quarterly portfolio)	10.926	9.828	10.499	20.67
Sharpe Ratio(%) (monthly portfolio)	206.991	159.332	175.41	478.605
Sharpe Ratio(%) (quarterly portfolio)	191.389	157.406	172.05	399.162
Standard Deviation(%) (monthly portfolio)	4.681	4.925	5.054	4.827
Standard Deviation(%) (quarterly portfolio)	4.784	4.784	5.174	5.147
Max. Draw Down(%) (monthly portfolio)	7.437	5.4	5.4	3.419
Max. Draw Down(%) (quarterly portfolio)	7.437	7.437	5.4	3.419

Compared with one of the best bond funds, Pimco's Total Return Fund PTTRX (managed by Bill Gross who won Morningstar's manager of the year award in 1998, 2000 and 2007), both monthly and quarterly adjusted portfolios outperform it. The following chart shows the comparison between PTTRX and the quarterly adjusted portfolio.


At the moment, both portfolios pick Loomis Sayles Bond Instl (LSBDX) as their investment.

In addition to actively managed bond mutual fund momentum, the index bond ETFs or mutual funds also exhibit good momentum. This is subject to other discussions in the future.

Disclosures: No Positions