Last Updated on 24 November, 2021 by Samuelsson
It is not always easy to find a strategy that works, let alone one that is quite easy to implement. But here is a simple momentum strategy that has beaten buy and hold with lower drawdowns.
What is momentum and how has it performed?
Momentum is an investing strategy that aims to invest only in the top-performing stocks at any point in time. The investors check the momentum of various stocks at regular intervals and sell off the ones that have fallen out of the top performers to buy the current top performers.
It is a well-known strategy that has performed well for many decades; however, it seems to do best on semi-long timeframes from 1 to 12 months. For example, one strategy that has performed well is to buy the stocks that have performed the best over the last six months. The strategy’s major drawbacks are big drawdowns and survivorship bias.
Understanding sector rotation
Sector rotation is an investing strategy whereby investors tactically move their money from one asset class or market sector to another. Most of the time, sector rotation is based on the momentum strategy. The idea is to periodically switch from one sector/asset class to another sector/asset class that is showing greater momentum.
A good example is switching between the S&P 500 ETF and Treasury bonds. A test on monthly rebalancing between SPY and TLT based on the best performance the prior month is shown below.
Why rotation between the SPDR S&P 500 ETF (SPY) and Treasury bonds (TLT) can work
Over the years, investors have always used the S&P 500 and Treasury bonds have for tactical asset allocation based on momentum and rotation. And the reason is that Treasury bonds are considered a safe-haven asset.
Hence, whenever there is uncertainty in the equity market, many investors seek to allocate more to risk-free assets like Treasuries to preserve their capital. This type of sector rotation is very popular because it usually lasts for a few months.
Testing momentum/rotation between SPY and TLT
The Monthly Momentum In SPY and TLT – strategy is based on monthly quotes in the SPY and TLT, and here is how the rotation works:
- The SPY and TLT are ranked every month based on last month’s performance/momentum
- The one with the best performance the prior month is bought
- The instrument is held for one month and the process repeated — this could lead to buying the other asset or continuing to belong the same instrument
This strategy is best performed in a tax-deferred account. Without slippage and taxes, this is what the equity curves look like:
Monthly switching between SPY and TLT.
As you can see, the strategy outperformed buy and hold for both ETFs but more importantly, it has a lower drawdown. Whether the strategy would continue to well is not clear, but what’s certain is that it performed well during the 2008/2009 financial crisis and the 2020 coronavirus-induced pandemic.
Momentum-based sector rotation can be a hedge against tail risk
Since tail risk increases chances of bankruptcy and behavioral mistakes, both traders and investors should watch out for it. Interestingly, given the fact that the rotation between the S&P 500 and Treasury bonds produced better returns than holding the S&P 500 and, at the same time, had substantially less drawdown, one can say that the strategy is a hedge against tail-risk. However, there is no guarantee that this will repeat in the future.