I really want to emphasis with these case studies that implementing a regime based asset allocation strategy is incredibly versatile. You can use economic regime filters to compliment any investment strategy for improved risk-adjusted returns. In this case study, I’m applying regime filters to a very popular strategy called Global Equities Momentum (GEM) outlined in the book Dual Momentum Investing by Gary Antonacci.
I used to work for a very large quantitative fund manager that was steeped in Efficient Market Hypothesis (EMH). To provide some context, the founder of the firm studied at the University of Chicago under Gene Fama. In fact, Gene, along with Ken French, were on the investment committee. The firm was very academically rigorous. They were strict adherents to research, and they had no qualms about using momentum to compliment their portfolios.
The momentum effect is not a panacea though. There are some very real downsides including large drawdowns, high turnover and high trading costs. The GEM strategy is an attempt to overcome some of these downsides.
Global Equities Momentum
In a nutshell, the GEM rules stipulate that your portfolio is fully invested in one of the following:
- US Stocks (SPY ETF).
- Non-US stocks (VEU ETF).
- Bonds (BND ETF).
The chosen market is dictated by both relative and absolute momentum (hence the title ‘Dual Momentum’).
Relative momentum is the comparison of returns of one asset class to another. In this case, we’re comparing US stocks to Non-US stocks and bonds.
Absolute momentum is the comparison of returns of a single asset class to itself.
Global Equities Momentum, Regime Enhanced
Enhancements to the above rules are as follows:
- No US stocks if the US economy enters Regime 4 (Low Growth, High Inflation). Instead, the number of available markets reduces down to 2: Non-US stocks or bonds to be determined by relative momentum.
- If the US economy is in Regime 1 (High Growth, Low Inflation), the allocation shifts to US stocks regardless of any relative momentum rules. Thus, the number of available markets reduces from 3 down to 1: US stocks.
- Finally, if Global Sentiment(1)This is a proprietary indicator available to newsletter subscribers free of charge. is negative, the allocation shifts to bonds (ignoring any momentum rules). Again, the number of available markets has reduced from 3 to 1, this time to bonds.
|GEM Dual Momentum||GEM Dual Momentum Regime Enhanced|
|Total Return (%):||46.07%||132.70%|
|Compound Annual Growth Rate:||3.50%||7.98%|
|Avg Annual Return (%):||3.63%||7.31%|
|Avg Monthly Return (%):||0.31%||0.68%|
|Standard Deviation (%):||0.61%||0.39%|
|Worst-case Drawdown (%):||-19.74%||-6.39%|
The portfolio simulation runs from April 2008 – December 2019.(2)Because of the inception date of the ETF’s being modelled and the requirement for a 12 month look-back for returns, the portfolio inception date is April 2008. While this is a limited sample window, at least some of the 2007-2008 US recession was captured as well as instances of all other regimes, ensuring adequate coverage of a variety of market conditions
The Regime Enhanced portfolio successfully deals with a lot of the pitfalls of momentum. Drawdown is dramatically reduced, portfolio volatility is almost halved and returns are almost 3x better.
These regime enhanced results are achieved without adding any further complexity to the GEM strategy. I’m simply using economic regimes shifts to override some of the momentum rules when they contradict, giving preference to the regime over momentum.
Regime based asset allocation improves the risk-adjusted returns of any portfolio.
|↑ 1.||This is a proprietary indicator available to newsletter subscribers free of charge.|
|↑ 2.||Because of the inception date of the ETF’s being modelled and the requirement for a 12 month look-back for returns, the portfolio inception date is April 2008. While this is a limited sample window, at least some of the 2007-2008 US recession was captured as well as instances of all other regimes, ensuring adequate coverage of a variety of market conditions|