Monday, September 21, 2015

Momentum Applied to Mutual Funds

Back in May, I posted A Guide to Creating Your Own Hedge Fund outlining how the application of momentum to the two worst performing funds within the Morningstar Multialternative category over the previous ten years would have provided an investor with better risk-adjusted returns than the Barclays Hedge Fund index and a lower correlation to equity markets.

Now, I'll share how a similar strategy going back a further ten years would have performed using randomly selected funds from the Morningstar Moderate Allocation / World stock universes. As an aside... this isn't too far removed from how I manage my own retirement money.

Narrowing the Universe for a Few Examples
  • Use the oldest share class within the Morningstar Moderate Allocation or World stock universe (oldest share classes typically have a relatively high fee structure - so I'll deem this conservative)
  • Only funds with a track record going back 20 years, the result of which is 69 funds in the Moderate Allocation universe and 44 funds in the World stock universe (this unfortunately adds to the survivorship bias, which makes the below figures a bit less conservative)
  • Randomly narrow the universe down to five funds; I used Excel's rand function for each iteration (this makes the results much more conservative in my view)

Allocation Rules

Random Momentum
  • If the 9-month return of the fund is > 0, allocate next month to the fund, otherwise to aggregate bonds
  • 20% weight to each fund's "path"
Dual Momentum (Top 3)
  • Pick five funds at random (as done with 'random momentum')
  • Take the best 3 performing funds over the previous 9-months and if > 0, allocate next month to the fund, otherwise to aggregate bonds
  • 1/3rd weight to top 3 at the previous month-end


Moderate Allocation

The below are my first 5 results (random iterations of the 69 funds) vs. an equal weight of all 69 funds with a 20 year track record and the S&P 500.

And the same rules applied to the Morningstar World stock fund universe

The challenge (and likely reason why it works) are the extended periods of underperformance an investor using momentum must deal with relative to a long only stock portfolio (these strategies have all materially underperformed during strong bull markets). I''ll save what I view as a potential fix to that for another day. For now, buyer beware... as of 8/31/15, less than 10% of funds within the Moderate Allocation and World categories had positive returns over the previous 9-months.