Exploring Dual Momentum Strategies

Dual Momentum Investing

Gary Antonacci‘s forthcoming book Dual Momentum Investing: An Innovative Strategy for Higher Returns with Lower Risk (New York: McGraw-Hill, 2014) is currently Amazon.com’s top-ranked book for “momentum investing”. Antonacci’s 2013 paper ‘Risk Premia Harvesting Through Dual Momentum’ (PDF) contains a preview – including a great opening discussion of why the momentum anomaly exists in the stockmarket and why behavioural finance factors are likely to be involved.

 

Antonacci distinguishes between two types of mometum strategies: (1) cross-sectional / relative momentum — used in long-short and index tracking strategies, and in the Relative Strength Indicator in ‘chartist’ technical analysis; and (2) absolute momentum – a time series phenomena where an asset’s prior price helps to determine its current price – used in trend-following.

 

Antonacci’s dual mometum framework combines both types of momentum to extract alpha from volatile asset classes. He uses a modular approach to portfolio construction. Treasury bills provide an initial hurdle rate for relative momentum, with a 12 month lookback period. Antonacci then uses absolute return increase the basis point return, whilst decreasing the portfolio’s volatility and maximum drawdown. He has tested the dual momentum strategy in fixed income, equity, and real estate REIT asset classes, and with other market factors such as credit risk and economic volatility.

 

The paper’s final paragraph summarises Antonacci’s dual momentum strategy:

 

The combination of relative and absolute momentum makes diversification more efficient by selectively utilizing assets only when both their relative and absolute momentum are positive, and these assets are more likely to appreciate. A dual momentum approach bears market risk when it makes the most sense, i.e., when there is positive absolute, as well as relative, momentum. Module-based dual momentum, serving as a strong alpha overlay, can help capture risk premia from volatile assets, while at the same time, defensively adapting to regime change. [emphasis added]

 

Dual momentum investing is thus an alpha extracting strategy that combines two different forms of momentum to diversify the portfolio, and to lower volatility. The two different forms of momentum identify a set of market assets that are highly probable to appreciate in value in the near-term, particularly in periods of economic volatility.

 

I suggest that momentum investors adapt to these market changes by possibly buying from distressed debt value investors near market lows that show signs of recent asset appreciation – and through identifying herding and overshoot conditions – selling to trend-following, news effect, and late-coming retail investors or mutual / pension fund managers. Thus, an understanding of game theoretic reasoning – as argued by the late trading psychologist Ari Kiev whilst at the hedge fund SAC – and population ecology models applied to market microstructure – might be helpful to momentum investors.

Predicting The Unthinkable In Financial Markets

The nuclear strategist Herman Kahn coined the phrase ‘thinking about the unthinkable’ in a series of black comic Air Force briefings that became On Thermonuclear War (Princeton University Press, 1960).  Faced with a year-long crisis in US credit markets analysts have embraced similar imagery in their forecasts of catastrophic risk.

Several different players in the financial ecosystem rely on the forecasts for multiple payoffs, one for their target audience and the other for themselves:

  • Research Analysts: (1) Provide clients with guidance and metrics to the market turbulence; (2) stand out in the pecking order of research firms and competing industry/sectoral analysts to remain relevant.
  • Investment Media: (1) Catastrophes as the source of drama and headlines to keep consumers engaged; (2) Financial and operational synergies of convergent media production.
  • Fund Managers: (1) An external input to valuation models for visiting potential firms to invest in; (2) A parameter for deciding on the asset classes, diversification and hedging for investment portfolios.

Some questions to ask in evaluating any catastrophic forecasts that predict the unthinkable:

  • What is the source, type and timeframe of the evidence presented?  The source may be company interviews, earnings calls, investment calls and trade seminars.  The type may be firsthand observation, market rumour, financial model, computer simulation or analyst conjecture.  The timeframe may be historical simulation of past data, quarterly forecasts or a longer time horizon for capital financing, global market entry, innovation pipelines or sustainability projects.  The source enables you to filter any possible agendas, the type refers to the information structure, whilst the timeframe often has embedded assumptions about cause-effect relationships, impacts, and the actions of others.
  • Why is the analyst making this forecast and could there be other agendas? Analysts have biases and personal theories that an attention economy might amplify.  At a group level this becomes self-reinforcing collective wisdom that may turn out to be flawed.  In embracing a current meme in a true believer stance analysts create a cognitive frame prevents them from considering alternative outcomes, options and possibilities.  At its most cynical this question is a reminder that forecasts are not objective or value-neutral, especially if the analyst is under pressure to generate earnings revenue or has a different private opinion to their public view.
  • What is the analyst’s track record in accurate forecasting?  This focuses on the analyst’s patterns of thinking and rhetoric in forecasts; how their performance compares to an industry, market or sectoral baseline; and the margin of error in their past forecasts.  This can be used to construct a brains syndicate, to filter out media reports and noise, to surface hidden assumptions and how they affect performance, and as a quality assurance check.
  • How might the catastrophic forecast be hedged? This shifts the focus from optimistic versus pessimistic views to the risk management focus on mitigative strategies and action planning.  To be effective, this requires an understanding of your risk profile and risk-return needs (risk averse, neutral or seeking), your time horizon, and the nature of the financial instruments, investment portfolio and markets to be used.