Risk Management Using Momentum

Includes: GLD, SHY, VBK, VWO
by: Lowell Herr


Momentum as a market risk reducer.

Global diversification made easy through ETFs.

Exponential moving averages as risk control indicator.

SHY as performance cutoff.

Cluster weighting momentum model for advanced investors.

While momentum is not an automatic inoculation against portfolio risk, it goes a long way toward preventing one getting caught in a three-sigma downside Black Swan event. What risks are we talking about as there are many types at work within a portfolio? To see a tabulation, check out this Investopedia list of risks. From this group, I will focus on the three I consider most important.

  • Systematic Risk - This is the type of risk we faced in 2008 and early 2009 as market events impacted all asset classes. Systematic risk is a condition where we have little or no control over the events.
  • Unsystematic Risk - The second major type of risk is unsystematic and it is one that attacks a single asset class or a smaller section of the market due to events or conditions that are not as wide spread as the events that cause systematic risk.
  • Market Risk - This is the volatility of the portfolio and is frequently measured by standard deviation (mean-variance) or less frequently, semi-variance.

Fighting systematic risk requires an ability to hedge a portfolio through means such as shorting, trading options, market timing, or a model designed to move one out of assets that are under downward pressure. The momentum model described below provides some relief.

Unsystematic risk is not as wide spread as systematic risk and therefore easier to combat through the use of the following momentum model. Global diversification through the use of ETFs is a first step in reducing unsystematic risk as one is spreading investments over hundreds of companies. Local negative events or the collapse of a single company has little impact on a well-diversified portfolio populated by a number of ETFs.

The momentum model seeks to smooth out market risk by lowering portfolio volatility, at least to the downside. We are not concerned about volatility to the upside as that is a desired goal. Just how does the momentum model work?

ETF Momentum Ranking Table: The following table includes a broad array of ETFs one might use to populate a portfolio. Most are commission free if one is a TD Ameritrade client. This particular spreadsheet ranks securities (ETFs in this example) based on three factors. 1) 50% weight is assigned to performance over the past three months or 91 days. 2) 30% weight is allocation to the performance over the past six months or 182 days. 3) The third factor is volatility and it receives the remaining 20% weight. These three metrics are used to rank the ETFs.

Rule #1: Sell the security if it is performing below SHY. In the following table, only GLD and VBK fall into this state.

Rule #2: Sell if the price of the security drops below its 195-Day Exponential Moving Average (EMA). GLD is the only ETF activating this sell signal.

These two rules go a long way toward keeping one away from major down markets.

Advanced warnings are included in the data table. For example, the "Golden Cross" is programmed into the spreadsheet and it is the X/O column. When the price of the 13-Day EMA crosses from above to below the 49-Day EMA, the cell turns red. This is an advanced warning signal, particularly when combined with the absolute acceleration percentage found in the far right-hand column.

Desired ETFs for purchase are: 1) Positioned or performing above SHY. 2) High overall rank. 3) Priced above their 195-Day EMA. 4) High absolute acceleration percentage. (VWO is an example.) 5) Positive "Golden Cross" indicator.

Investors wanting to take portfolio risk management to the next level will find Cluster Weighting Momentum (CWM) as that step. CWM is a method of finding low correlated securities and concentrating the portfolio in those investments. Think of it as a sophisticated method of diversification where the securities are funneled into clusters based on correlations and the top securities within each cluster become possible investments so long as they outperform SHY, our cutoff ETF of choice.

There is a tendency to focus on portfolio return and shove portfolio risk to the background. That is until we are hit with a 2008 event. This momentum model is set up to keep portfolio risk in the forefront of investor thinking.

Disclosure: I am long VTI, VOE, VBR, RWX, VNQ, PCY, DBC, BND, JNK. 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. I hold nearly all the ETFs found in the data table.