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Even In Slow Boring Fixed Income Investing, Hot Hands Are Still Hot

|Includes: AGG, BND, BWX, HYG, IEF, IGIB, JNK, LQD, MBB, MUB, PCY, iShares Short Treasury Bond ETF (SHV), SHY, TLT, USIG

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 our previous 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).

ValidFi maintains various types of bond fund momentum based strategies. One model portfolio 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 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.

PTTRX_10102009
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. We will have more follow up articles to detail these investing strategies.

Disclosures: No Positions