Optimal Momentum: A Global Cross Asset Approach

Abstract

Momentum is widely accepted among academic researchers as one of the strongest return generating factors, yet it remains largely unknown by the investing public. This paper explores that dichotomy by examining momentum from a practical point of view. Using exchange traded fund data from 2002 through 2010, we compare industry, style and geographic applications of momentum. Global stock index funds using four geographic regions give the best momentum results, but with a high level of volatility.

Instead of lowering portfolio volatility by the usual method of adding fixed income securities to our momentum portfolio, we take an alternative approach of integrating fixed income into the momentum process itself. Fixed income securities become active in the portfolio only when they exhibit stronger momentum than equities. This creates a regime change overlay with momentum used for tactical, as well as strategic, asset allocation. The results are extraordinary risk adjusted returns at a reasonable level of volatility. Adding fixed income and other diversifying assets, such as gold, to momentum-based portfolios gives substantially more improvement than it does to non-momentum portfolios.

We validate eight years of ETF momentum results with thirty-four years of index data. On this longer data set as well, cross asset momentum substantially increases risk adjusted returns and significantly enhances the benefits of global diversification.

We show momentum to be a practical, powerful and parsimonious method for global asset allocation and portfolio construction. When used with selective diversification across different asset classes, momentum may also be an attractive enhancement to traditional mean variance portfolio optimization.

Keywords: momentum investing, global asset allocation, price momentum, asset allocation models, asset allocation portfolios, momentum trading, momentum, relative strength, GTAA, ETFs

JEL Classification: C00, C10, C50, C61, G00, G10, G11, G14, G15