My wife is a nutrition and health coach.
She tells me that the most effective advertising is Before & After weight loss pictures. People just LOVE to see that transformation that others have made in their lives by taking on a diet or a training plan.
Here’s a couple of examples to show you what I mean:
Well, today I’m going to share with you some BEFORE & AFTERs in the area of investing.
A Momentum Investing Diet
I will show you why you should go on a diet. A Momentum Investing diet. And I’ll do so using BEFORE & AFTER charts.
Now, a Momentum diet is special diet. You don’t need to subtract anything from your existing portfolio. You just ADD a few momentum holdings, and you’re good to go.
The easiest way to add momentum is to buy a Momentum Active ETF. But then, you don’t know what you’re buying. Does this ETF hold only pure high-conviction momentum holdings, or is it merely skewed towards Momentum? And by how much? Does it contain stocks with time-series momentum? Cross-Sectional momentum? Idiosyncratic momentum? Go figure. Good Luck.
Settling on a momentum ETF is….OK. Kinda like drinking Herbalife smoothies for weight loss. It can work to some extent, but then, is it a sustainable way to keep weight down?
The best way to add momentum IMO is using the Quantitative Momentum screener on my site. By building your own momentum portfolio, you know exactly what you own, and exactly how the stocks were selected. I’m very open in describing inner workings of the model.
tl;dr My point is that adding Momentum stocks to any Value Investing portfolio results in increasing average annual returns and reducing portfolio’s volatility and drawdowns. That’s because Momentum and Value both have a positive and high return expectation, coupled with a low correlation between them.
And it’s the reason why all Value investors need Momentum.
A low correlation between two assets means that on occasion when one asset appreciates, the other depreciates, and vice versa. If both assets have positive expected returns, i.e., they both tend to appreciate over time, combining the two assets into a single portfolio will result in a smoother upward journey. In our case, the Value portfolio and a Momentum portfolio are two such assets.
There’s an old Wall Street saying that “diversification is the only free lunch in investing.” Well, that’s true ONLY IF the assets you’re diversifying with are not fully correlated, as the case for Value and Momentum.
Every portfolio can benefit from adding some Momentum
Our first BEFORE figure is a Magic Formula performance chart that we re-created using the Portfolio123.com platform. The portfolio contains 25 stocks selected out of the Russell 3000 index, based on Greenblatt’s Magic Formula ranking system which he described in his Little Book That Beats the Market. We perform yearly rebalance, replacing the stocks whose rank dropped below the upper 40th percentile.
No surprises – the Magic Formula beats the market, with an average annual return of 12.9% vs. 5.13% for the S&P500. It does so with a standard deviation of 23.81%, a measure of volatility which is significantly higher than the S&P500’s 14.62%.
It means that investing in the Magic Formula is a roller coaster of sharp up and downs. It can quickly drain an investor mental resources and cause him or her to lose faith in the strategy.
We will now add a Momentum Portfolio of 20 stocks to the mix. The 20 Momentum stocks are selected using our Quantitative Momentum Screener and restricted to a market cap of $200M or higher. The Momentum portfolio is rebalanced every six months.
The momentum portfolio performance:
As shown in the chart above, the Momentum portfolio’s performance is superb, with an annual average return of 32.35% vs. 5.21% for the S&P 500 during the same period. Sharpe is very high, at 1.35.
Yet it comes with excessive volatility nonetheless – a standard deviation of 21.24%, vs. 14.64% for the S&P 500, on average, during the entire period. The Momentum portfolio was very volatile also during the last three years. Its standard deviation, at 18.41%, was almost twice that on the S&P 500, at 10.5%.
Now, let’s combine the two. In the combined portfolio, the Magic Formula’s portion comprises of 60% of the total portfolio, and the momentum portfolio comprises of the remaining 40%. Upon each by-yearly rebalance, we return to the 60/40 partitioning.
Wow. Isn’t that amazing?
The annual average returns of the combined portfolio hadn’t suffered. On the contrary, it rose to 20% vs. the 12.9% of the original Magic Formula portfolio we had used.
But the real story is the volatility. The combined portfolio’s standard deviation (the “Model” column in the table above) is now only 20.04%, down from 23.81% (the “MAGI” column) for the original Magic Formula portfolio. Max drawdown is also reduced at -50.44%, vs. -54.80%.
Clearly, a Magic Formula investor is better off adding a Momentum porion to his or her investing portfolio.
Let’s check now a few additional examples.
The following is a Value Investing portfolio that was built using the Ben Graham’s Strategy for the Defensive Investor. It includes 15 stocks selected out of the S&P 500.
Nice strategy, indeed. The annual average return is 11.64% vs. the S&P 500’s 5.13%. The standard deviation since inception is only 11.64%, much lower than the S&P 500’s 14.62%, which is excellent. Even the max drawdown is much smaller than the markets, at -31.92% vs. the S&P 500’s max drawdown of -55.19%.
With such low volatility figures to start with, could Momentum make any difference and reduce the volatility further? Or will it merely boost returns?
AFTER – now with a Momentum portfolio of 20 stocks, a market cap of $2000 market or higher:
And the answer is –
YES. Adding Momentum was a great idea here as well. True, the standard deviation did not improve (lower is better), and stayed about the same at 11.80% vs. 11.64% for the Value portfolio alone. Max drawdown was even impaired a bit and was a bit higher than before adding Momentum.
BUT average annual returns have grown from 11.48% before adding Momentum, to 15.79% for the combined portfolio, more than 400 basis points per annum.
Thus, even an investor in an ultra-low-volatility strategy such as the Ben Graham’s defensive value strategy – is better off adding a momentum portion to his portfolio.
Let’s see one last example. This time, we’d start with a Quantitative Value portfolio that was built using our Quantitative Value screener.
BEFORE – A Quantitative Value of 30 stocks with a market cap of $200M or higher:
As expected, AMAZING performance.
24.44% per year, on average, vs. the S&P 500’s with 5.13%. Volatility is higher than the markets, at 16.42%. Max drawdown is this case is lower than the markets, at -43.42% vs. -55.19% for the S&P 500.
AFTER – and now with Quantitative Momentum portfolio of 20 stocks with a market cap of $200M or higher, rebalanced every six months:
You would have guessed. The standard deviation was slightly reduced, from 16.42% before to 16.29% after. Max drawdown came down from -43.42% to -42.07%. Annualized returns appreciated to 27.92%.
Momentum is a wonderful addition in this case as well.
Everybody needs some momentum.
It helps the low-volatility portfolio boost its returns, and helps the high-volatility portfolio become less volatile (without compromising returns).
Reducing volatility is important. Don’t dismiss it as being semantic. The lower the volatility, the easier it gets to hold on to the portfolio through tough periods, and not unthoughtfully dump stocks when you should hold on to them (and even buy more).
Stay Calm and go on a Momentum Diet. Check out the Quantiative Momentum Strategy now.
(Image: ONS Global Media)