01 Apr Learning From Newfound Research's "Momentum and Diversification"
The paper outlines a framework for combining Momentum and Diversification across a spectrum of static asset allocation portfolios.
In this article, Absolute Momentum will be used interchangeably with trend following or time series momentum. Relative Momentum will be used interchangeably with cross-sectional momentum or relative strength.
The paper starts by showing that momentum applied on US Equities and Treasuries delivered similar returns and Sharpe ratio compared to S&P500 with significant reduction in max drawdowns.
The paper then proceeds to incorporate Diversification to Momentum:
To consider diversification, we can explicitly construct a spectrum of portfolios we would invest in, and run our momentum model on the portfolios to determine a point in time allocation. This parallels the methodology of taking a universe of stocks and investing based on a momentum screen or score but here we are treating each individual portfolio as a single asset. Treating each portfolio as if they are their own asset class allows us to capture the effects of diversification without the momentum selection process.
The static portfolio provides the diversification while the momentum framework focuses on the behaviour of the portfolios as individual assets.
To build the diversified strategy we first construct 4 static portfolios consisting of a US Equity/Treasury allocation of 80%/20%, 60%/40%, 40%/60% and 20%/80% rebalanced on an annual basis. We add a 100% US Equity and 100% Treasuries option to complete a 6 choice spectrum of investments for the strategy. As before the strategy will on a monthly basis invest in the allocation option that has the greatest trailing one year Sharpe ratio.
As noted in the table below, the Diversified strategy showed an improvement in both total and risk adjusted return compared to the simple Sharpe switching strategy over the period (1977-2014).
Source: Newfound Research
Next the paper selected 4 S&P Target Risk indexes which comprise a common global risk spectrum for portfolios. The MSCI All Country World Index and Barclays 1-3 year US Treasury Index is added to complete a 6 option portfolio spectrum.
The same process using 6 and 12 months lookback produced results below.
Source: Newfound Research
The paper then proceeds to describe an approach to incorporate a risk minimum and risk aversion parameter to increase the flexibility of this framework across different investor profiles. The process will take into account investor’s risk tolerance.
Research Paper: Momentum and Diversification: A powerful risk-adjusted combination
Authors: Newfound Research
Company: Newfound Research