Dual Doubts…

It seems that there has been a lot of interest in dual momentum investing out there of late. And I can’t say that I’m entirely surprised. After all, the momentum story was interesting and convincing enough for me personally to move me off of my strong predilection for boglehead style passive investing (for better or for worse.)

But as with any approach there are real negatives to dual momentum investing, both considered and unconsidered, so it would seem to be wise to ponder these downsides closely, and to open my favored approach up to real honest criticism. Which is what I will start to to do in this post.

Let’s start then with my favorite skeptical take on dual momentum investing which came from reader Ming;

As a Boglehead believer and a subscriber to general life rule of thumb that…anything that looks too good to be true most likely is. And so when I looked at the chart of the dual momentum strategy and that insane gain WITH lower volatility, I was both very excited and also very skeptical….
…But my question is this. And during my brief research into momentum strategies, I saw a video by a Columbia professor discuss this in 2010…so this has been known for a while. Why then, if this is so obvious and relatively easy to implement and seems to have almost guaranteed higher returns AND lower risk…why then are not all the professional managers and active mutual funds on Wall St making a killing from this strategy? Is this something new that has been discovered? Why should we lay people then just invest in a “dual momentum mutual fund” pay a management fee, but then get rewarded with much higher returns and lower risk without having to do the monthly calculations?
So in other words, if this active management/market timing strategy works so well, then why isn’t everybody in on this already?

I respect this criticism (probably because I share a lot of the same beliefs as the author.)

I am still a a huge believer in low-cost passive indexing.

I believe that risk and reward are necessarily related when it comes to investing. (I.e. there are no free rides.)

I too am suspicious of approaches that look too good to be true. And dual momentum’s increased annualized return in the setting of markedly decreased drawdowns admittedly can feel illusory.

I agree dual momentum is incredibly easy to implement, which makes me wonder how this momentum anomaly can possibly persist?

So let me try then to answer these questions in turn.

Why don’t more individual investors use momentum?

I think there are at many reasons why dual momentum is not more widely adopted among individual investors.

The first is that the momentum story is unintuitive. If prices move up-and-down based on rational decisions that the cumulative market and its individual players make about value (The dominant hypothesis of active management), or even if price movement is simply a random walk with no logic to it (The hypothesis behind passive management), then momentum simply should not exist.

So whether you are a true boglehead or a dedicated trader, the momentum story simply doesn’t resonate with your view of the market at first blush.

Momentum cannot be convincingly attributed to a risk story, nor can it be convincingly be used as evidence of the existence an efficient market. (it can be attributed to the inefficiencies of institutional investment structures, and to the pervasive irrational performance chasing tendencies of human beings, but who really wants to bet on that?)

Simply put, almost no matter what your investing bias is, momentum probably does not fit neatly into your organizing picture of how the market works.

In Daniel Kahneman’s excellent book Thinking Fast And Slow, he describes several heuristics, which are mental shortcuts that we take in order to rapidly and efficiently make sense of our worlds. Many of these heuristics fall under the umbrella of “representativeness.”

Representativeness describes how we tend to quickly and unconsciously bend incoming data to fit into our own working preconceptions and (quite often inaccurate) perceptions of how the world works.

By this quality of representativeness, momentum, although it is all around us and it’s evidence is pervasive, becomes invisible to us, and thus very difficult to commit to.

In my mind this blindness to human irrationality is the major hurdle that prevents investors from embracing momentum investing to the exclusion of all other approaches. But it is not the only hurdle.

The second reason that dual momentum investing is difficult to adopt, is that it is uncomfortable in practice.

As with any active approach there is tracking error which means that there will be times when your chosen approach gets creamed by the market. This is always uncomfortable, but it is particularly uncomfortable when the justification for your approach is hard to put your finger on. Simply put; betting on human irrationality will seem twice a awkward when the market is behaving rationally and kicking your butt.

Furthermore, on any given day a dual momentum investor will have a much less diversified portfolio then a “buy and holder.” Whereas a boglehead will generally hold international stocks and domestic stocks, a momentum investor will probably hold one or the other. More to the point a boglehead will generally hold some bonds and some stocks, whereas a dual momentum investor will often own either all stocks or all bonds.

All of this means that the day-to-day ride of the dual momentum investor will be much bumpier and more uncomfortable on average than the experience of a well diversified passive investor, even though, if past is prologue, the dual momentum investors bear market drawdowns will generally be much less severe.

And do not discount the importance of this discomfort on a day-to-day basis. I will admit that I personally experience the stock market as a series of days, not a series of years or decades. And losses always feel much worse to me than gains feel good.

Another  issue that likely prevents many individuals from pursuing the dual momentum strategy is that it is both more work than a passive approach, and less personally satisfying than an active approach.

Many people simply do not want to think about or fiddle with their investments on a monthly basis. A yearly rebalancing is about all they’re interested in and I get that. Not everyone plays with stock charts during their free time for fun.

On the other side of the coin there are the active stock pickers. They don’t mind expending a lot of energy thinking about tactical moves,  so why don’t they switch to a pure momentum-based approach?

My guess is that for this type of investor it is much more intellectually satisfying to analyze the balance sheets of companies in order to find hidden value, or to read the tea leaf like messages hidden in the technical analysis of stock charts, and to be proven right, than it is to put all of your money into long-term treasuries simply because they have outperformed everything else over the past six to twelve months.

When you invest dual momentum you will (sadly) not feel remotely like this guy.

When you do well with an active approach it must feel like a real affirmation of your own intelligence (no personal experience here, sadly,) but when you do well with momentum, you just feel kind of randomly lucky (at least that’s how I feel.)

Finally the mere small size of the community that advocates for this approach is a deterrent for employing the dual momentum strategy.  If you are trying to figure out how to invest your money there are large communities of advice givers who will advocate for passive boglehead type strategies, Graham Dodd style value approaches, Dividend growth investing or even trend following, to name a few.  The Dual momentum movement is basically Gary Antonacci and a few amateur acolyte’s (like me.)  Turning your back on a community of like minded investors feels awkward and cultish (which I alluded to in this post entitled “jumping off of a cliff.“)  We humans are social animals, first and foremost, after all.

So why aren’t the pros using this strategy already?

In short…they are.

Momentum is everywhere and it is used by almost every professional money manager.

As an example, this recent article reported Goldman Sachs research found that last years hedge fund performances were highly influenced by individual fund exposure to Apple, and that hedge fund managers were more likely than the broad market to overweight Apple positions.

And it’s easy on the structural level to understand why this is the case. As a money manager what you get paid is determined to both by your performance and by the amount of money that you have under management. This means that taking a contrarian position and an unpopular stance on an investor favorite (like underweighting Apple) which loses to the market can be a very destructive thing for your bottom line.

This means that big institutional investors are incentivized to participate in positive momentum which only strengthens the momentum effect.

More to the point, many of the greatest traders around are primarily momentum (or trend following) traders.

Whether it be in equities, currencies, managed futures, using momentum has been a persistent and powerful way successfully play the market.  In fact a recent book,  by Greyserman and Kaminski reportedly found that trend following has signifiantly outperformed buy and hold with significantly lower draw downs when compared back to the 17th century!

As a more specific anecdote in support of this observation that successful traders use trend following take this quote from legendary trader Paul Tudor Jones…

I teach an undergrad class at the University of Virginia, and I tell my students, “I’m going to save you from going to business school. Here, you’re getting a $100k class, and I’m going to give it to you in two thoughts, okay? You don’t need to go to business school; you’ve only got to remember two things. The first is, you always want to be with whatever the predominant trend is. My metric for everything I look at is the 200-day moving average** of closing prices. I’ve seen too many things go to zero, stocks and commodities. The whole trick in investing is: “How do I keep from losing everything?” If you use the 200-day moving average rule, then you get out. You play defense, and you get out.

How can we be sure that the momentum anomaly will persist?

Obviously we cannot. Nobody knows what will continue to work or not work in the future.

But this is kind of an empty criticism since the same criticism is valid when used against any style of investment, including traditional buy and hold.

As an example the average boglehead is making an explicit assumption that the equity risk premium (i.e.The observation that stocks will be more lucrative investments than bonds, cash, commodities etc, and that bonds will be less volatile) will persist into the future. This assumption is based on nothing more than a model that posits that risk and reward are linked, and back testing.

Which is not to say that all bets are equally smart. But if you want to determine the intelligence of a bet a priori, one could do a lot worse than to bet on momentum.

Gary Antonacci makes a very convincing argument in his book Dual Momentum about the pervasiveness of the momentum anomaly. Everywhere it is been looked for (US equities, foreign equities, emerging market equity’s, currencies, commodities, bonds, futures… ) it has been present. And the power of the momentum anomaly has persisted long after its initial description in US stocks in 1993, which suggests that the anomaly is extremely difficult (If not impossible) to arbitrage away.

Furthermore I personally find the underlying behavioral story about momentum to be exceedingly convincing. There are a few things that I have a more firm belief in than the persistence of human irrationality, and our tendency to chase performance.

So for me at least this combination of a convincing underlying story and the almost unrivaled quality of the data supporting the validity of the momentum observation was enough for me to change my approach from passive diversification to a duel momentum approach in my tax sheltered accounts.

And at the end of the day since any asset allocation strategy or trading decision is little more than a bet on the future, we investors can rarely do better than to simply decide where to put their pennies down and to stick with our (well considered) approaches through thick and thin.

**As I have previously described, trend following using a 200 day moving average, and an absolute momentum screen are almost identical in their effect. (Read: lower drawdowns.) An 12 month absolute momentum screen simply trades a little bit less frequently.