January 2016, which began as the worst start to a year ever for US equities, saw a rebound in the last two weeks of the month to become just the worst January for equities since 2009. Of course, the loss of momentum in US stocks had been developing since the S&P500 hit an all-time high in May 2015.
Over the past year, I posted twice on the theme of momentum. In March, in a post titled Chronic Dissonance: Boom or Bust, I compared two global macro investment frameworks that were sending quite different signals. The first was the High Frequency Momentum Investing (HFMI) approach, which closely follows developments in macroeconomic data to track the business cycle, inflation trends and central bank policy guidance to assess the likely direction of interest rates, exchange rates, equity prices, commodity prices and credit spreads. The second was the Balance Sheet Capital Preservation (BSCP) approach, which follows less-watched data on capital flows, national and sectoral balance sheets, debt levels, credit spreads and market liquidity, and interprets high-frequency economic data against the backdrop of balance sheets and valuation levels.
I remarked at that time that the investment views of some of my favourite practitioners of these two frameworks were diverging and offering very different investment advice. The HFMI approach was bullish on global growth prospects and its strategists were recommending going all in on the "growth trade", characterized by overweight positions in equities, select commodities and credit and underweight positions in government bonds, especially long duration bonds. The BSCP approach was much more bearish, emphasizing the continued rise in global debt ratios, the overbuilt or bubble conditions that exist in some key economies and sectors, and the persistence of deflationary pressures. Given my views that valuations across many asset classes were stretched, I sided with the BSCP approach, favouring a more defensive portfolio, holding 45% equities, 25% bonds and 30% cash with a high exposure to US dollar denominated assets.
In April, I returned to the momentum theme with a post titled The Big No and the Big Mo, in which I argued that the US Fed's decision to move toward what I called "The Big No", monetary policy normalization, would bring to an end "The Big Mo", the momentum trade that had seen the steady rise in the valuations of risk assets that had accompanied the use of unconventional monetary policies.
Looking back, I think that both of these posts stood up pretty well as the year unfolded. After rallying early in the year, US high-yield credit peaked at the end of February. US equities peaked in mid-May. From mid-May until the end of January, the US equity ETF (SPY) returned -9.1% in USD terms, the Canadian equity ETF (EWC) returned -26.2%, the US high yield credit ETF (HYG) returned -9.4%, and the US 10-20yr Treasury bond ETF (TLH) returned +5.0%. It seems that the concerns of strategists following the BSCP approach were borne out. A momentum shift occurred.
Antonacci's Dual Momentum Investing
As these events were unfolding, I was reading Gary Antonacci's new book, Dual Momentum Investing. It is easily the best investment book I read last year, and one of the best I have ever read. I am not going to review the book, but I will say that even if Antonacci's strategy doesn't suit your investment style, you will learn a great deal about asset return momentum, portfolio theory and asset allocation from his book.
Since some of the best strategists I have followed over the years have employed some form of momentum investing, I was intrigued to see what evidence could be mounted to support the approach. On this front, Antonacci writes in the Preface to his book (p. xiv),
Momentum, or persistence in performance, has been one of the most heavily researched finance topics over the past 20 years. Academic research has shown momentum to be a valid strategy from the early 1800s up to the present, and nearly across all asset classes. After many years of such intense scrutiny, the academic community now accepts momentum as the "premier anomaly" for achieving consistently high risk-adjusted returns.
In my opinion, the best part of the book is Chapter 8, where Antonacci provides a simple, practical method of constructing an investment approach based on Dual Momentum, which can be implemented using the same kind of low-cost global ETFs that I use for the portfolios that are tracked in this blog.
Antonacci distinguishes between "absolute momentum" and "relative momentum". Absolute momentum is an absolute return concept, an asset's excess return (i.e., its return less the riskless t-bill return) over a given look back period. If an asset's return has been going up more than the T-bill return, it has positive momentum; if less, it has negative momentum. Relative momentum is a relative return concept, which compares an asset's excess returns to those of its peers over a given look back period. For example, one could compare the returns of the S&P500 with returns on other equity indexes, such as the Euro Stoxx, or the Japanese Topix, or the Canadian S&PTSX300, or the FTSE Emerging Markets index to judge relative equity momentum.
The Dual Momentum approach, suggested by Antonacci is a rules-based approach that utilizes a combination relative and absolute momentum. It is well described by Ben Carlson on his Wealth of Common Sense blog as requiring only three ETFs,
The relative momentum rule requires a comparison of the past 12 month returns for U.S. versus international stocks. The absolute momentum rule compares the higher trending of these two stock markets to the past 12 month returns for t-bills. If the S&P 500 [or SPY] has a higher return than both international stocks [ACWX] and cash [i.e. t-bills], you hold the S&P. If international stocks have a higher return than the S&P and cash, you hold international stocks. If cash has a higher return than stocks, you hold the bond fund [TLH].
The chart below shows total returns, as growth of $100,000 in USD terms, for SPY (green line), ACWX (blue line) and TLH (yellow line) from March 31, 2008 through Jan 29, 2016.
Antonacci backtested the Dual Momentum approach and found that over the 40-year period from 1974 to 2013, the approach "has an average annual return of 17.43% with a 12.64% standard deviation, a 0.87 Sharpe ratio, and a maximum drawdown of 22.7%. This almost doubling of the [MSCI All-Country World Index] comes with a reduction of volatility of 2%".
So What's Happened to Momentum Lately?
The chart below shows the 12-month total returns for SPY (green), ACWX (blue), and TLH (yellow) through the end of January 2016. [Total returns include all dividend and/or interest payments].
The month-end 12-month return on SPY has fallen below zero, as has the return on ACWX. By my reckoning, this implies that the Dual Momentum approach would shift out of SPY into TLH, the bond ETF, at the opening of markets on February 1, 2016.
One concern some investors may have about the Dual Momentum approach described above might be that that it is a concentrated portfolio holding only one ETF at a time. Another concern may be that using a 12-month return, the approach might not perform well in the event of a sudden meltdown in financial markets. Nevertheless, Antonacci's Dual Momentum Approach has an enviable back-tested track record and opens up a wealth of possible ideas for structuring global ETF portfolios.
How I Look at Momentum
Momentum has shifted. After several years of stronger 12-month total return momentum for global equities relative to other asset classes (including bonds, credit, inflation-linked bonds (ILBs) and commodities), in December global bonds return momentum overtook that of global equities in CAD terms, and in January 2016 global equities sank to the lowest momentum asset class. Even the best commodity ETF that I track, GLD, the gold ETF had stronger 12-month momentum than SPY, the best equity ETF.
The chart below splices together the 12-month returns on the top performing equity ETFs, top-performing bond ETFs (including credit), top performing ILB ETFs, and top performing commodity ETFs that we track. In the case of global equities, for example, over the 36 months ending December 2015, momentum leadership was held by the US large-cap equity ETF (SPY) for 11 months, the US small-cap ETF (IWM) for 9 months, the Japanese equity ETF (EWJ) for 8 months, the Eurozone equity ETF (FEZ) for 6 months, and the Canadian equity ETF (XIU) for 1 month. Since this blog is focussed on Canadian investors in global ETFs, the returns in the chart are shown in Canadian dollar terms.
The chart shows that, in CAD terms, 12-month momentum in global equities has exceeded that of the other asset classes in 33 out of the past 37 months. The exceptions were January 2015, October 2015, December 2015 and January 2016. On each of these occasions, the best global bond ETF return exceeded the best global equity ETF return. And on each of these occasions, the best global bond ETF was the 10-20yr US Treasury bond ETF (TLH).
I have examined an investment approach using this data and a rule that says hold only the ETF with the best 12-month return momentum (Mom12) determined at the end of each month. Also, to alleviate concerns about sudden corrections and concentration in a single ETF, I have also looked at employing 6-month momentum (Mom06) and choosing the two top performing ETFs across all of the asset classes. The chart below shows returns that would have been generated by these two approaches, as well as returns from the more diversified portfolios that we normally track, from the beginning of 2013.
Over the past three years, the two portfolios based on simple momentum rules would have outperformed all of the other more diversified portfolios that I normally track. Over the entire period, both the 12-month momentum portfolio (Mom12) and the 6-month momentum portfolio (Mom06) have generated returns of over 13.5% annualized in CAD terms, about 2% per annum above the best of the diversified portfolios and about 9% per annum better than a simple all-Canadian 60/40 ETF portfolio. As might be expected, the momentum portfolios have had higher volatility than the other more diversified portfolios, but the higher volatility has generated higher returns over the recent period.
It is also worth noting that, at the end of December, the Mom12 portfolio fortuitously shifted out of equities (specifically EWJ, the Japanese equity ETF) into bonds (specifically TLH, the US 10-20yr Treasury Bond ETF) and thereby managed a monthly gain for January of 1.3% in CAD terms. The Mom06 portfolio wasn't so lucky; based on 6-month momentum it held 60% SPY and 40% TLH in January, which resulted in a -0.5% monthly loss. Nevertheless, both portfolios outperformed the Global 60/40 and the Canada 60/40 portfolios, which returned January losses of -2.6% and -1.2% respectively.
Conclusions
I believe that there is strong academic support for employing momentum in asset allocation in order to achieve higher risk adjusted returns. Gary Antonacci has provided an easy-to-execute momentum approach which has outstanding backtest results. I have identified two rather simple approaches using the global ETFs that I track. My results over the past three years discussed above, while not a robust backtest, are encouraging. In particular, I like the ability of the suggested momentum portfolios to take currency movements into account. During the recent period of Canadian dollar weakness, these momentum approaches would have had Canadian investors out of Canadian dollar denominated ETFs for virtually the entire period. When the Canadian dollar rallies back, it will be reflected in the relative total return momentum (in CAD terms) of the ETFs.
This does not mean that I will make a wholesale shift away from assessing global macro factors in my asset allocation decisions. Both the High Frequency Momentum Investing and the Balance Sheet Capital Preservation approaches that I have written about remain useful and insightful approaches to asset allocation. But I'm convinced that adding the momentum factor can improve investment results.
While investors are surely hoping that the worst is over for 2016, the momentum approach is still suggesting caution. Momentum rules point to overweighting (if not fully allocating) portfolios to bonds.
One year ago, I posted that "The Bank of Canada Should Open the Door to a Rate Cut". The following week, the BoC "shocked" economists and the business media by cutting its policy rate 25 basis points to 0.75%. I do not agree with those who say that it shocked the bond and currency market because those markets were already pricing about a 50% chance that a rate cut was coming in 1Q15.
A year ago, I focused on the likely impact the sharp drop in commodity prices (led by the collapse in crude oil prices) would have on the economy. I said,
When the price of oil [and other commodities] falls, Canada's terms of trade (ToT) weakens. When the price of commodities falls relative to the price of other goods and services, the price of Canada's exports falls relative to the price of its imports. When the commodity terms of trade weaken, Canada's gross domestic income weakens. This negative shock to income is shared across the corporate sector, the government sector and the household sector. While some energy consuming industries will benefit, total corporate profits will fall. Government revenues will fall, causing most governments to curtail discretionary spending. While commuters will benefit from lower gasoline prices, the lower Canadian dollar will make imports of finished consumer goods and services more expensive. As housing and other asset prices weaken against a backdrop of record high household debt-to-income ratios, consumers will be reluctant to spend any windfall bestowed by lower energy prices. Many will prefer to save rather than spend the temporary boost to disposable income.
I noted a year ago that the Canadian dollar had weakened sharply, but that the depreciation had not kept pace with the weakening in the commodity terms of trade (which is simply equal to the Bank of Canada Commodity Price Index divided by the core CPI). The chart below updates this relationship.
The BoC's two rate cuts, in January and July 2015, combined with the US Fed's bias to hike rates, which it finally acted upon in December 2015, helped the depreciation of the Canadian dollar to keep pace with the continuing sharp decline in the commodity terms of trade.
I don't think many people recognize that Canada's commodity terms of trade in January 2016 are 28% weaker than they were at the lowest point of the Great Recession of 2008-09. And the prospect today for a quick rebound is not there as it was in early 2009, when the shale oil revolution had hardly begun, when China and other emerging economies were growing strongly and when the G20 was in the process of applying huge coordinated monetary and fiscal stimulus to the global economy. Indeed, most G20 leaders have recently been more focussed on cutting fossil fuel consumption than on providing stimulus for global growth.
In Canada, new governments at the federal level and in energy-rich Alberta, have promised to act on climate change, to increase infrastructure spending, and have already raised top personal income tax rates (while lowering "middle-class" tax rates). The combined effect of these measures over the next few years is unlikely to provide much, if any, real stimulus to growth. Indeed, continued uncertainty over resource royalties, payroll taxes for government run pension plans, and carbon taxes or cap and trade policies to address climate change seem likely to act as further meaningful drags on business investment and real GDP growth.
So the Bank of Canada should stay on course and cut the policy rate by another 25 basis points next week on January 20.
This is the recommendation that I made to the Bank of Canada in my role as a member of the C.D. Howe Monetary Policy Council (MPC). Some members of the were reluctant to call for another rate cut because they were concerned that doing so could trigger a further sharp depreciation of the Canadian dollar. Several suggested that the currency could overshoot its' "fair value" to the downside. One even suggested that the BoC could trigger a currency crisis.
In my opinion, these fears are way overblown. The depreciation of the Canadian dollar so far has just kept pace with the deterioration of Canada's commodity terms of trade. Ahead of the BoC decision next week, economists are about evenly split in their forecasts with an increasing number calling for a rate cut as commodity and equity markets weakened sharply over the first two weeks of January. The bond and currency markets have already priced in a better than 60% probability of another 25 basis point rate cut on January 20. If the BoC decides not to cut rates the Canadian dollar is likely to rally, preventing it from acting as the cushion to the terms of trade drop that it needs to be.
I would also point out that those arguing against a rate cut are mostly based in Ontario and Quebec. As we have seen in the past in Canada, regional views on appropriate monetary policy sometimes vary. Those in the non-resource regions of central Canada appear to want to have the benefits of lower crude oil and other commodity prices (in the form of lower consumer prices for gasoline and lower resource input costs for for manufacturing), but don't want to have to share the costs in the form of a weaker Canadian dollar that cushions the impact on resource industries but increases central Canadians' costs of imported food, Florida vacations and BMWs.
BoC Governor Poloz (and the Governing Council) has pursued the same approach to monetary policy in the face of a severe commodity price shock that his predecessors Mark Carney, David Dodge or Gordon Thiessen would have followed. If the current Governing Council is concerned about the Canadian dollar falling too much, it should cut 25 bps to 0.25% and provide forward guidance that the policy rate is expected to remain at that level, conditional on underlying inflation remaining on a projected path back to the 2% target by the end of 2017.
Let's get one thing straight: 2015 was a lousy year for Canadian investors.
A stay-at-home 60/40 investor who invested 60% of their funds in a Canadian stock ETF (XIU), 30% in a Canadian bond ETF (XBB), and 10% in a Canadian real return bond ETF (XRB) had a total return (including reinvested dividend and interest payments) of -3% in Canadian dollars. And the Canadian dollar weakened 16% against the US dollar, so in US dollar terms the all Canadian 60/40 Portfolio had a total return of about -19%.
The focus of this blog is on generating good returns by taking reasonable risk in easily accessible global (including Canadian) ETFs. To assist in this endeavour, we track various portfolios made up of a combination of Canadian and global ETFs. This allows us to monitor how the performance of the ETFs and the movement of foreign exchange rates affects the total returns and the volatility of portfolios.
Since we began monitoring these portfolios at the beginning of 2012, we have found that the Global ETF portfolios have all vastly outperformed a simple stay-at-home portfolio. As you will see in this post, that gap widened significantly in 2015.
Global Market ETFs: Performance for 2015
In 2015, with the USD and JPY both appreciating a stunning 19% and the EUR appreciating 7% against the CAD, the best global ETF returns for Canadian investors were in Japanese and US equities and USD-denominated government bonds. The worst returns were in commodities and Canadian equities. The chart below shows 2015 returns, including reinvested dividends, for the ETFs tracked in this blog, in both USD terms and CAD terms.
Global ETF returns varied dramatically across the different asset classes in 2015. In USD terms, only 4 of the 19 ETFs we track posted positive returns, while 15 ETFs posted losses for the year. In CAD terms, 16 of 19 ETFs posted gains, while just 3 posted losses.
The best gains were in the Japanese equity ETF (JPY) which returned a stunning 29.9% in CAD. The US Long (10-20 yr) Treasury Bond ETF (TLH) was second best, returning 20.6%, followed by the S&P500 ETF (SPY), which returned 20.4% in CAD. Other big gainers included USD-denominated Emerging Market bonds (EMB) 20.2%; US inflation-linked bonds (TIP) 16.9%; US Investment Grade Bonds (LQD) 16.5%; Eurozone equities (FEZ), 14.2%; US small cap stocks (IWM) 13.6%; and US high yield bonds (HYG) 13.0%. Canadian ETFs with positive returns included Canadian Long Bonds (XLB) 3.8% in CAD terms; Canadian real return bonds (XRB) 3.0%; and Canadian corporate bonds (XCB) 2.1%.
The worst performer, by far, was the commodity ETF (GSG), which returned -34.1% in USD and -21.6% in CAD. Second worst was the Canadian equity ETF (XIU) which returned -7.8% in CAD terms (including dividends), followed by the emerging market equity ETF (EEM), which returned -0.3% in CAD terms.
Global ETF Portfolio Performance for 2014
In 2015, the Global ETF portfolios tracked in this blog posted solid returns in CAD terms when USD currency exposure was left unhedged, but negative returns when USD exposure was hedged. In a November 2014 post we explained why we prefer to leave USD currency exposure unhedged in our ETF portfolios.
A simple Canada only 60% equity/40% Bond Portfolio returned -3.0%, as mentioned at the top of this post. Among the global ETF portfolios that we track, the Global 60% Equity/40% Bond ETF Portfolio (including both Canadian and global equity and bond ETFs) returned 9.2% in CAD terms when USD exposure was left unhedged, but -0.3% if the USD exposure was hedged. A less volatile portfolio for cautious investors, the Global 45/25/30, comprised of 45% global equities, 25% government and corporate bonds and 30% cash, gained 8.1% if unhedged, but -1.2% if USD hedged.
Risk balanced portfolios outperformed in 2015 if unhedged, but underperformed if hedged. A Global Levered Risk Balanced (RB) Portfolio, which uses leverage to balance the expected risk contribution from the Global Market ETFs, gained a robust 14.1% in CAD terms if USD-unhedged, but had the biggest loss of -4.4% if USD-hedged. An Unlevered Global Risk Balanced (RB) Portfolio, which has less exposure to government bonds, inflation-linked bonds and commodities but more exposure to corporate credit, returned 10.3% if USD-unhedged, but -3.4% if USD-hedged.
While the returns on our global ETF portfolios greatly outperformed the all Canadian portfolio, we should not pat ourselves on the back too much. It is worth remembering that in USD terms, all of these portfolios had negative returns. Nevertheless, if the objective was capital appreciation in CAD terms and capital preservation in USD terms, these portfolios did the job.
Three Key Policy Events of 2015
In my view, there were three key policy events that left a mark on Canadian portfolio returns in 2015. The first was the Bank of Canada's decision to cut the policy rate in January. The second was the Chinese central bank's decision to devalue to Chinese Yuan in August. The third was the US Fed's decision to hike the US policy rate in December.
The impact of each of these three decisions can be seen in the chart below which tracks weekly portfolio returns since the beginning of 2012. The Bank of Canada's decision to cut the policy rate boosted all of the ETF portfolios in January, but the unhedged global ETF portfolios saw a much larger and more sustained jump in returns as major foreign currencies appreciated sharply against the Canadian dollar.
The PBoC decision to devalue CNY caused a correction in global equity markets and contributed to the Fed's decision to hold off from hiking rates in September. The Fed pause saw equity markets stabilize somewhat until December when the Fed followed through on its promised rate hike, a move which kept the Canadian dollar under downward pressure. The Global ETF Portfolios posted solid gains in 4Q15, while the Canada only ETF Portfolio added to its losses for the year.
As we enter 2016 in a continuing uncertain environment, characterized by significant global divergences in growth and central bank policies, and depressed oil and other commodity prices, remaining well diversified across asset classes, with substantial exposure to USD-denominated assets and with an ample cash position continues to be a prudent strategy.
