SMSFundamentals | Jul 11 2023
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Dual Momentum Investing: A Potent Tool For Savvy Investors
In the investing landscape, seeking out strategies that can provide an edge is essential for savvy investors. Dual momentum investing is a potent tool that combines historical performance analysis and benchmark comparisons to identify investments with strong potential.
By harnessing the forces of absolute and relative momentum, this strategy focuses on capturing outperforming assets while steering clear of underperforming ones. The article delves into the intricacies of dual momentum investing, discusses its implementation process, explores its potential, and highlights the risks.
-Dual momentum investing applies absolute momentum (compared to historical performance) and relative momentum (compared to a benchmark) to identify investments with strong performance potential
-The approach involves selecting asset classes, computing absolute and relative momentum, ranking assets based on momentum scores, allocating capital accordingly, and periodic rebalancing
-Risks of dual momentum investing include performance reversals, limited diversification, reliance on short-term anomalies, and the potential for overfitting and data mining bias
By Anuj Sharma
Dual Momentum Investing
Dual momentum investing (introduced by Gary Antonacci) unites two types of momentum for the identification and selection of investments. It systematically captures strong-performing assets while avoiding weak-performing ones. The strategy has the potential to generate returns beyond the benchmark.
The first type of momentum used in dual momentum investing is absolute momentum. It quantifies the relative strength of an investment or asset against its own historical performance. If an asset demonstrates positive absolute momentum, it signifies that the asset has outperformed its historical average, and consequently, it can be considered a favourable investment. Conversely, if an asset’s performance signifies negative absolute momentum, it reflects that the asset has underperformed its historical average and should be avoided.
The second type of momentum used in the strategy is relative momentum. It assesses the relative strength of different assets by comparing their performance against a benchmark. Investments with strong relative momentum, signifying that they have outperformed the benchmark, are preferable, while investments with weak relative momentum should not be selected.
By combining absolute and relative momentum, dual momentum investing identifies investments that have both strong absolute and relative performance. The logic behind the strategy is that assets with positive absolute momentum are more likely to continue their upward trend, while assets with strong relative momentum are likely to outperform their peers and the market.
Implementation of the Dual Momentum Approach
The implementation of the dual momentum approach requires careful analysis of the financial market's unique characteristics and dynamics.
Implementation of the approach starts with selecting a class of assets, for instance, indices or stocks listed on the Australian bourse, government bonds, commodities, or Exchange-Traded Funds (ETFs). To ensure diversification, assets that are representative of different sectors and industries can be selected.
After that, it requires the calculation of absolute momentum and relative momentum. It leads to the quantification of dual momentum, which is generally the sum of absolute momentum and relative momentum scores; based on that, an ideal investment can be selected. Further, selection of the ideal investments requires ranking the assets through a filter based on momentum scores, like an average for smoothing values.
For better comprehension, sector indices listed on the ASX can be analysed. Here is the analysis of historical averages of dual momentum of the sector indices.
Here, it can be observed that S&P/ASX 300 Metal & Mining (XMM) led the charge in the average momentum score among the sector indices. The data signifies that XMM is a clear outperformer after the averages got smoothed during 2017.
Figure 1: XMM has the strongest dual momentum average during 2017–2023.
Data source: YahooFinance (price data) and author’s compilation
Meanwhile, the allocation of capital can be executed through momentum-based ranking during portfolio construction. For instance, a higher percentage of capital can be allocated to assets with stronger momentum while reducing or eliminating allocations to assets with weaker momentum.
Notably, rebalancing is essential for the portfolios through a regular review of the performance and adjusting the asset allocations as needed. It involves replacing lower-momentum assets with ones with better momentum. Rebalancing can be done periodically, such as monthly or quarterly, to maintain the desired asset allocation and capture ongoing momentum opportunities.
By systematically implementing the strategy and maintaining constant monitoring, the portfolio can integrate the potential for higher returns.
Performance of the Dual Momentum Strategy
Here, the process under the dual momentum strategy is executed by selecting sector indexes as the asset class to demonstrate the performance of the strategy. A quarterly time frame was selected as the basis for performance evaluation and asset selection.
After selecting the asset class (sector indices), the quarterly close price has been derived for all the indices listed in the chart from December 2012. From the price data, quarterly returns were computed. Then the calculation of absolute momentum is performed. Here, absolute momentum is equal to the index's quarterly return minus the average quarterly return.
In detail, the quarterly return is computed by dividing the difference between the close price and the initial price (for the quarter) by the initial price. Whereas the average quarterly return was computed by dividing the sum of returns by the number of quarters passed since December 2012 (a continuous calculation of the average).
In short, the difference between the price return during the current quarter and the average quarterly return led to absolute momentum.
Similarly, to calculate relative momentum, the index’s price return is compared with the price return of the ASX200 (XJO) for the quarter. Here, Relative Momentum is equal to asset return minus benchmark return.
During the financial years 2017–2020, XMM had the strongest dual momentum average. Based on the above-mentioned analysis (Figure 1), XMM has been identified as a favourable investment under the dual momentum strategy. For the evaluation of long-term consistency and outperformance, the annual returns of XMM and the benchmark (ASX 200) are compared.
Figure 2: Comparison of annual returns generated by XMM and XJO based on an initial investment of $10,000
Source: Author’s compilation
Interestingly, the annual returns generated by the selected index, XMM, have outperformed the market, ASX200 (XJO), for the last three consecutive financial years, that is, 2020–21, 2021–22, and 2022–23, irrespective of macroeconomic conditions.
Therefore, a good understanding of the dual momentum strategy can assist investors in identifying assets with a superior return.
Risks of Dual Momentum Investing
Dual momentum investing, like any investment strategy, carries inherent risks that investors should be aware of.
One of the primary risks of dual momentum investing is the potential for performance reversals. Historical performance is not a guarantee of future results, and assets that have exhibited strong momentum in the past may experience a reversal in their performance. It can lead to losses if the selected assets fail to sustain their momentum.
Additionally, a dual momentum strategy may concentrate on a specific class of assets or sectors that have exhibited strong momentum. It can lead to limited diversification, which increases the overall risk of the portfolio. If the selected assets or sectors experience a downturn, the lack of diversification can amplify losses.
While dual momentum aims to exploit market inefficiencies, it is important to acknowledge that markets are generally efficient over the long term. The strategy should not rely on short-term market anomalies, as they can disappear or be corrected, leading to diminished effectiveness.
Further, dual momentum strategy involves backtesting historical data to identify assets with strong momentum. However, there is a risk of overfitting the data or falling victim to data mining bias, where the strategy appears successful in the past due to chance rather than a sustainable edge. It can result in underperformance when the strategy is applied to real-time market conditions.
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In conclusion, dual momentum investing offers savvy investors a potent tool to potentially achieve superior returns. By combining absolute and relative momentum, this strategy identifies investments with strong performance potential while avoiding underperforming assets.
However, it is crucial for investors to consider the risks involved. Performance reversals, limited diversification, reliance on short-term anomalies, and the potential for overfitting and data mining bias are important factors to keep in mind. By understanding and carefully implementing the dual momentum strategy, investors can capitalise on potential opportunities while managing the associated risks.
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