Adaptive Dynamic Momentum: Improving Trend Identification

Updated June 10, 2023

If Einstein had never discovered that E = mc2, we may have never unlocked the importance of the links between energy, the speed of light and mass.

If Louis Pasteur hadn’t experimented with bacteria in his lab to determine what caused disease, millions of lives would have been lost due to less-than-sanitary practices in medicine and other fields.

The concepts of gravity and evolution, the discovery of DNA, the invention of penicillin, and millions of other inventions and experiments have created a better, smarter, healthier and richer world.

Investors are not exempt from the processes of adaptation, evolution and discovery, and they, too, can continually benefit from major advances in portfolio management (see What Is Tactical Asset Allocation? How Does It Improve Returns?).

Asset Allocation

In about the fourth century, Rabbi Aha proposed the following rule for asset allocation: “One should always divide his wealth into three parts: a third in land, a third in merchandise, and a third ready to hand.”

Asset allocation took a great leap forward in 1952 when Professor Harry Markowitz derived the optimal rule for allocating wealth across risky assets in a static setting now referred to as Strategic Asset Allocation where the basic premise is to select, buy and hold a diversified basket of assets through full market cycles.

1966 ushered in a series of 4 cyclical bear markets in both equities and fixed income which lasted until 1982.

The large drawdowns associated with Strategic Asset Allocation (aka “Buy and Hold”) during this period focused interest on Tactical Asset Allocation where the basic premise is to select and own the best performing assets within a diversified basket. This is a process which requires more active management and more frequent rebalancing.

1982 brought the beginning of a 40 year bull market in both equities and fixed income which ushered a wide-spread shift to Strategic Asset Allocation. While the performance of Strategic Asset Allocation lagged that of Tactical Asset Allocation, less active management was required to maintain portfolios.

A number of investment strategists believe that in 2022 we entered a period which will prove similar to 1966-1982 in requiring very active portfolio management.

What Is Momentum?

Momentum is the empirically observed tendency for rising asset prices to rise further, and falling prices to keep falling. The concept of momentum is best explained by behavioral economics rather than classical economics. To put it simply, the human traits of greed and fear explain much of the reason why momentum is a persistent factor in the markets.

Table 1 and the accompanying chart was prepared from annual data compiled by Callan. It demonstrates the annual variation across 9 different assets from best (green) to worst (red).

Here we examine the potential of capturing the returns from the 3 best performing asset classes each year starting with $1000 invested at the end of 1999. Cash Equivalents takes the low end at $1,453 and Small Cap Equity takes the high end at $4,122. $1000 invested equally each year across all 9 classes would yield the Average of $3,160 while owning the Best 3 rises to an astronomical $37,820.

Capturing the full returns of the Best 3 each year is a pipe dream, however the chart does demonstrate the large benefit of selecting the strongest and discarding the weakest.

In the case of our Tactical Asset Allocation strategies, we perform that task monthly so we have a much better chance of riding winners to improved performance not to mention reduced drawdowns from the losers.

Traditional Momentum Measures

There is a large body of published academic and commercial research on Tactical Asset Allocation. Much of that body of work is focused on measuring price momentum over fixed length periods or even a weighted average of fixed length periods (for example 20 weeks or weighted averages of 1+4+13+26 weeks). The change is calculated and compared for each fund in a basket to determine those with the strongest momentum.

The Achilles Heel of this methodology is two fold:

• Using a fixed length fails to recognize and accommodate the many reasons why cycle lengths tend to vary across asset classes, sub-classes, and even funds.
• Worse yet, the cycle lengths are selected either arbitrarily or based on optimization using the best results from past history.

Enter Adaptive Dynamic Momentum

I devoted 5 years of research and testing to create a far better measure of momentum. Adaptive Dynamic Momentum (ADM) calculates a wide range of regressions for each fund, each rebalance period, and uses the length which best fits current conditions. It then performs another set of calculations using a secondary length which is a derivative of the primary to validate the trend. Finally, it normalizes the results for each fund member of the basket for comparison of both strength and confidence.

In short, ADM:

• is self-adapting to current market dynamics
• allows for more accurate trend identification
• provides a smoother equity curve.

What does this mean for investors? It adds up to improved returns, decreased drawdowns, and greater confidence.

Funds To Be Used In Comparing ADM to ROC

The graph below continues with the dataset used in our previous white paper, What Is Tactical Asset Allocation? How Does It Improve Returns?

The Vanguard Balanced Index Fund is the poster child for Strategic Asset Allocation. Vanguard Balanced is widely considered a suitable core portfolio holding for all investors. Vanguard Balanced applies a fixed 60% allocation to equities and 40% allocation to fixed income.

While Open End mutual funds provide greater depth of history; we prefer to use Exchange Traded Funds (ETFs) wherever possible. We will use two Vanguard ETFs with infill from their similarly indexed Open End Funds (OEF) for depth of history.

• VTI (inception 2001) & VTSMX: the Vanguard Total Stock Market Index Fund includes US large, small, and mid cap stocks. Its holdings are nearly identical to those of the equity portion of the Vanguard Balanced Fund. Its OEF equivalent is VTSMX with history back to 1992.
• BND (inception 2007)& VBMFX: the Vanguard Total Bond Market Index Fund, invests in US government  and corporate investment grade bonds.  Its holdings are nearly identical to those of the fixed income portion of the Vanguard Balanced Fund. Its OEF equivalent is VBMFX with history back to 1987.

A 60% allocation to VTI and 40% allocation to BND approximates the results of VBINX, the Vanguard Balanced Index Fund for which there is no comparable ETF.

Summary statistics for each set (22 years: January 2000 through December 2022)

• Vanguard Fund: Gain @ $254,046, Compound Annual Growth Rate@ 5.7%, Maximum Monthly Drawdown @ 32.6%
• Tactical with ROC: Gain @ $427,408, Compound Annual Growth Rate@ 7.5%, Maximum Monthly Drawdown @ 21.1%
• Tactical with ADM: Gain @ $718,486, Compound Annual Growth Rate @ 9.6%, Maximum Monthly Drawdown @ 14.3%

Adaptive Dynamic Momentum is impressively accurate in identifying the direction and degree of momentum in an investment trend as well as the probability that that trend will continue. No one wants to purchase a previously successful fund that proceeds to fall off a cliff.

It is important to note that Adaptive Dynamic Momentum is not a surefire cure for the doldrums experienced by tactical strategies when markets are experiencing a shift in trends. The true benefits of Tactical Asset Allocation are always measured across a full market cycle (see What Is A Full Market Cycle And Why Should I Care?). Regardless, Adaptive Dynamic Momentum steadily and repeatedly outperforms single and weighted period momentum across virtually every specialized and diversified basket of funds I’ve tested.

Why Adaptive Dynamic Momentum and Why Now?

Research shows that we reached the end of major market, fixed income, and credit cycles that began in 1982, some 40 years ago. Now more than ever, investors need strategies which can adapt dynamically to rapidly shifting cycles in equity valuations, interest rates, fiscal and monetary policy, and inflation.

We have far more fund choices than were available during the 1966-1982 period. Our fund baskets are more diversified, which makes adapting to shifts in domestic and international equities, fixed income, real estate and commodities markets that much more critical for investors.

Conclusion

Equity and fixed income markets continue to shift and change and will become even more challenging in the future. This demands that we adapt with new and improved technologies. Fortunately, the Adaptive Dynamic Momentum strategy for Tactical Asset Allocation is incredibly dynamic and adaptive to both today’s and tomorrow’s market cycles, representing a major improvement over previous algorithms. The development of Adaptive Dynamic Momentum has significantly raised the bar for portfolio performance using Tactical Asset Allocation.