Asset allocation is crucial for investors. Investing in a single asset carries the risk of significant losses if its price crashes, which may take a long time to recover. Additionally, emotional decision-making could lead to selling at the lowest point. Therefore, to prevent substantial capital loss, it is essential to diversify investments across various asset classes to mitigate risk. One of the theoretical foundations for this approach is Portfolio Theory, a key concept in modern finance. A detailed explanation of this theory is provided in the following link:

Portfolio Theory Explanation

If you understand the importance of asset allocation, the next question to consider is, "Which assets should you invest in?" A good starting point is index funds (or index ETFs). Vanguard founder John Bogle advocated for long-term investment in the market portfolio, as this allows investors to fully benefit from the profits generated by companies. Long-term investment in index funds is advantageous in terms of tax efficiency and lower transaction costs. It also helps prevent irrational buying and selling decisions by investors. For a more detailed discussion on this topic, please refer to the link below:

Index Fund Investment

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Managing Market Risk with Bonds and Diversified Assets

However, when investing in index funds for the long term, a major remaining risk factor is market risk. One way to reduce the volatility caused by market risk is to incorporate bond funds into the portfolio. Bonds tend to move inversely to stocks, meaning they can help mitigate losses when the stock market declines. Additionally, bond interest payments provide a stable source of income.

In his 1949 book The Intelligent Investor, Benjamin Graham suggested a 50:50 allocation between stocks and bonds as a standard ratio. Later, Vanguard introduced an index fund with a 60:40 stock-to-bond ratio, which achieved great success. John Bogle also proposed investing in bonds based on one’s age, with the remaining portion allocated to stocks.

Beyond bonds, investors can diversify their portfolios by including international stocks, emerging market stocks, commodities, and gold. However, there is a crucial principle to keep in mind when adding assets:

• Since the portfolio is meant to be maintained for the long term with minimal trading, included assets must have a long-term upward trend.
• Assets should provide compensation for the risks associated with holding them.
• Even if an asset is highly volatile in the short term, it must demonstrate sustained long-term growth to provide a risk premium and contribute to wealth accumulation.
• Ideally, assets should exhibit continuous growth for at least 100 years, considering human lifespan and retirement planning.

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The Challenges of Traditional Asset Allocation

To reduce portfolio volatility, the assets included should have low correlations with each other. A portfolio composed of highly correlated assets limits the effectiveness of diversification. For example, if bonds decline along with stocks during a market downturn, it becomes difficult to avoid overall portfolio losses. In contrast, incorporating low-correlation assets maximizes the benefits of asset allocation, ultimately improving the likelihood of achieving investment objectives.

However, traditional asset allocation strategies are now facing new challenges:

• As global markets become increasingly integrated, correlations between asset classes are rising.
• The correlation between U.S. stocks and other developed markets has increased, reducing the effectiveness of international diversification.
• The suitability of bonds for long-term investment has been questioned since their historical returns underperform stocks.
• Emerging market stocks lack sufficient historical data, making their long-term reliability uncertain.
• Some investors use commodity futures as an inflation hedge, but concerns exist regarding their lack of risk premium and long-term viability.

These practical issues have made risk management through asset allocation more challenging than before. As a result, some argue that the era of "free lunches" in investing is coming to an end. While the benefits of asset allocation cannot be entirely dismissed, it is becoming increasingly evident that existing strategies need to be improved.

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Introducing the Dual Momentum Strategy

A noteworthy strategy in this context is Gary Antonacci’s Dual Momentum Strategy. This approach combines relative strength momentum and absolute momentum, and Antonacci has demonstrated that incorporating absolute momentum can significantly reduce downside risk in a portfolio.

Understanding Momentum Investing

Momentum refers to the tendency of investment returns to persist. Assets that are performing well tend to continue performing well, while assets experiencing losses are likely to keep declining. Momentum is categorized into:

1. Relative Strength Momentum (Cross-Sectional Momentum): Compares an asset’s performance against similar assets and selects the best performers while eliminating the weakest.
2. Absolute Momentum (Time-Series Momentum): Evaluates an asset’s own historical performance and determines if it has generated positive excess returns.

Historical Evidence of Relative Strength Momentum

Before academic validation, several traders applied relative strength momentum:

• Jack Dreyfus: "If you want to ride the up escalator, you should bet on people already on the up escalator rather than the down one."
• William O’Neil: "Buy strong stocks, sell weak ones."
• Nicolas Darvas: Used breakout trading, buying stocks at new highs and selling when momentum weakened.
• Richard Driehaus: Focused on sector rotation and leading stocks.

Academic research has also confirmed relative strength momentum as a valid investment strategy. A pioneering study by Narashiman Jegadeesh and Sheridan Titman, titled "Returns to Buying Winners and Selling Losers", provided strong empirical support for the momentum effect. The effectiveness of momentum strategies has been confirmed across various asset classes, including U.S. and international equities, industry sectors, stock indices, government bonds, corporate bonds, commodities, currencies, and even residential real estate.

As research findings accumulated, major investment firms such as AQR Capital Management and BlackRock’s iShares introduced momentum-based financial products, making momentum investing more accessible and convenient for investors.

However, studies have also revealed a critical drawback of relative strength momentum: while it enhances returns, it does not reduce volatility or Maximum Drawdown (MDD). In response, Gary Antonacci argued in his book Dual Momentum Investing that by combining absolute momentum with relative strength momentum, investors can achieve not only higher portfolio returns but also lower volatility, reduced MDD, and improved Sharpe ratios. Now, let’s explore absolute momentum.

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Absolute Momentum and Its Benefits

Absolute momentum can be understood as time-series momentum, meaning it predicts the future performance of an asset based on its past performance. Absolute momentum examines an asset’s own past returns relative to a risk-free rate(typically the return on government bonds):

• Positive absolute momentum: If an asset’s excess return is greater than zero, it maintains its positive trend.
• Negative absolute momentum: If an asset’s excess return is negative, it indicates a downward trend.

Simply put, if an asset has been generating profits over a certain period, its absolute momentum value is positive. If the asset has been incurring losses, its absolute momentum value is negative. The principle behind absolute momentum is based on the assumption that returns tend to persist over time—meaning that if an asset has a strong momentum trend, it is likely to continue in the same direction.

Key Differences Between Absolute Momentum and Relative Strength Momentum

Absolute momentum has several distinct characteristics compared to relative strength momentum:

• Number of Assets Required -- Relative strength momentum requires at least two assets to compare their performance. -- Absolute momentum, on the other hand, can be applied to a single asset.
• Portfolio Composition -- Relative strength momentum eliminates weaker assets from a portfolio and retains only the strongest-performing ones. -- Absolute momentum allows all assets to remain in a portfolio as long as they maintain positive momentum, enabling greater diversification and lower short-term volatility.
• Risk Mitigation in Down Markets -- Absolute momentum helps exit positions early during market downturns, significantly reducing downside risk. -- This makes absolute momentum a potential hedging tool against extreme market events.

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Testing the Absolute Momentum Strategy

To evaluate the effectiveness of absolute momentum, we applied it to the S&P 500 index:

• If S&P 500’s 12-month excess return is positive, buy the index.
• If S&P 500’s excess return is negative, hold cash.

Backtest Results (1950–2024):

The S&P 500 index has shown continuous growth over time, and its buy-and-hold strategy results in a higher average annual return. However, applying the absolute momentum strategyreduces both volatilityand maximum drawdown (MDD). Consequently, when assuming a risk-free rate of 3%, the Sharpe ratioof the absolute momentum strategy is higherthan that of the buy-and-hold approach.

While a performance comparison chart might suggest that investing solely in an index fund or an ETF tracking the S&P 500 is the best approach, the absolute momentum strategyproves particularly effective during periods of severe market downturns, such as the dot-com bubble of the early 2000sand the 2008 financial crisis. By using absolute momentum, investors can avoid significant portfolio declinesduring these crises.

Additionally, absolute momentum helps prevent investors from panic-selling at inopportune timesdue to psychological stress in bear markets. It acts as a sort of stop-loss mechanism, protecting assets from large declines while ensuring that investors re-enter the market once the trend turns positive again.

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Dual Momentum: Combining the Best of Both Worlds

The Dual Momentum Strategy takes advantage of:

• Relative strength momentum, which enhances returns by selecting the strongest-performing asset.
• Absolute momentum, which reduces downside risk by avoiding weak assets.

Dual Momentum Implementation

1. Select the best-performing asset over the past 12 months.
2. Apply absolute momentum: Check whether this asset's excess return over the past yearis positive or negative.
   • If positive excess return, invest in the asset.
   • If negative excess return, invest in short-term or medium-term bonds.

Gary Antonacci backtested this strategy using:

• S&P 500
• MSCI ACWI (excluding U.S.)
• U.S. Aggregate Bond Index

Performance Results (40-Year Period)

The table below presents the performance resultsfor different strategies, including:

• ACWI Dual Momentum Strategy
• ACWI Relative Momentum Strategy
• ACWI Absolute Momentum Strategy
• ACWI Benchmark (Buy & Hold)
• ACWI 70% / U.S. Aggregate Bond Index 30% Portfolio

Compared to its benchmark, the ACWI (All Country World Index), the Dual Momentum Strategy delivered nearly double the returns. Additionally, it exhibited lower volatility (standard deviation) and MDDthan a portfolio mixed with bonds. Because it successfully increased returns while reducing volatility, it also achieved the highest Sharpe ratioamong the strategies tested.

Even when dividing the 40-year period into 10-year segments, the data remained consistent, demonstrating the robustness of the Dual Momentum Strategy.

If you're looking for a valuable resource on this topic, _Dual Momentum Investing_is an excellent bookfor non-professional investors who need a strategy for lifelong investing. For a deeper understanding, please refer to the link below.

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What’s Next?

By learning about Dual Momentum, we have added another powerful toolto protect and grow our assets. However, Dual Momentum is not without its weaknesses.

In the next post, we will explore additional strategiesthat can complement asset allocationwhile incorporating Dual Momentumfor enhanced portfolio performance.