A Diverse Momentum System Using Vanguard Allocation Funds

One of the criticisms of momentum systems is they are prone to crashes when momentum reverts. The system highlighted in this article can be implemented using any number of “life style” or target-risk funds or ETFs.  The system chooses from a small number of funds that reflect a range of asset allocation models.  The purpose is to employ a diverse, momentum-based asset allocation system.  Rather than allocate based on momentum to singular asset classes which increases the potential for momentum crashes, we allocate to asset allocation models themselves.

The tests were conducted using Portfolio Visualizer.  If you have not checked out their site I highly recommend this free tool.  Also, for additional research on this topic please see this award-winning paper by Corey Hoffstein of Newfound Research which served as the original inspiration for these tests.

I ran 5 tests using Vanguard Target-risk funds and the Vanguard S&P 500 Index Fund (VFINX).  The Target-risk funds used were LifeStrategy Conservative Growth (VSCGX) , LifeStrategy Growth (VASGX) , LifeStrategy Income (VASIX) , LifeStrategy Moderate Growth (VSMGX) .  According to Vanguard these funds are “a series of broadly diversified, low-cost funds with an all-index, fixed allocation approach that may provide a complete portfolio in a single fund. The four funds, each with a different allocation, target various risk-based objectives.”  The funds allocate different percentages to bonds (international and domestic) and stocks (international and domestic).

The tests consisted of two simple momentum systems I frequently use on Scotts Investments.  The first is a simple relative strength system where the best performing asset based on trailing returns is purchased.

The seconds is a “dual momentum” system that holds the best performing fund based on trailing returns.  A second filter is used, absolute momentum, to switch the best performing asset to cash if its total returns were below the risk-free rate of cash over the lookback period.  This is similar to my Dual Momentum Portfolio, which is inspired by a paper written by Gary Antonacci and available on Optimal Momentum.  Antonacci’s book, Dual Momentum Investing: An Innovative Strategy for Higher Returns with Lower Risk, also highlights his specific system  in greater detail.

The test results for the relative momentum system is below. All tests were from 1996 – present.  The first model used a single performance window of 5 months. The best performing fund was held, and trades were performed at the start of each month.  For comparison purposes an “equal-weight” version each portfolio is also provided but since these are asset allocation funds the comparison is a bit redundant (equal weight is essentially a balanced fund itself):

Timing Model Assets
Ticker Name
VSMGX Vanguard Lifestrategy Moderate Growth Fund
VASIX Vanguard Lifestrategy Income Fund
VSCGX Vanguard Lifestrategy Fund Conservative Growth Fund
VASGX Vanguard Lifestrategy Growth Fund
Portfolio Initial Balance Final Balance CAGR Std.Dev. Best Year Worst Year Max. Drawdown Sharpe Ratio Sortino Ratio Stock Market Correlation
Timing Portfolio $10,000 $51,597 8.78% 8.53% 24.22% -10.53% -18.49% 0.75 1.14 0.84
Equal Weight Portfolio $10,000 $35,621 6.73% 8.56% 19.57% -22.73% -32.75% 0.53 0.75 0.96
S&P 500 Total Return $10,000 $48,177 8.40% 15.47% 33.36% -37.00% -50.95% 0.45 0.64 0.99

What if we add VFINX to the pool of potential assets? We would expect higher volatility with potentially higher returns since a 100% stock allocation is held at various times ( you will also see the equal weight portfolio has slightly higher returns/volatility because it is tilted towards stocks with its allocation to VFINX):

Portfolio Initial Balance Final Balance CAGR Std.Dev. Best Year Worst Year Max. Drawdown Sharpe Ratio Sortino Ratio Stock Market Correlation
Timing Portfolio $10,000 $70,161 10.51% 10.21% 33.21% -10.53% -18.49% 0.8 1.24 0.82
Equal Weight Portfolio $10,000 $38,242 7.12% 9.85% 21.35% -25.59% -36.63% 0.51 0.73 0.98
S&P 500 Total Return $10,000 $48,177 8.40% 15.47% 33.36% -37.00% -50.95% 0.45 0.64 0.99

Eq Curve

Returns and standard deviation increase, which may have been expected.  However, max drawdown and the worst year remained the same, so adding a 100% stock allocation did not impact our biggest loss.

Next, we test a dual momentum approach with a 12 month look back period.  The top 1 fund is purchased based on 12 month returns, but only if the returns are also greater than the return on the risk free rate of cash.  Testing the 4 life style funds (excluding VFINX) yielded the following results:

Portfolio Initial Balance Final Balance CAGR Std.Dev. Best Year Worst Year Max. Drawdown Sharpe Ratio Sortino Ratio Stock Market Correlation
Timing Portfolio $10,000 $49,142 8.51% 8.78% 22.26% -7.61% -16.17% 0.71 1.08 0.73
Equal Weight Portfolio $10,000 $35,621 6.73% 8.56% 19.57% -22.73% -32.75% 0.53 0.75 0.96
S&P 500 Total Return $10,000 $48,177 8.40% 15.47% 33.36% -37.00% -50.95% 0.45 0.64 0.99

What if we include VFINX?

Portfolio Initial Balance Final Balance CAGR Std.Dev. Best Year Worst Year Max. Drawdown Sharpe Ratio Sortino Ratio Stock Market Correlation
Timing Portfolio $10,000 $59,952 9.62% 10.45% 33.21% -6.73% -17.29% 0.71 1.09 0.73
Equal Weight Portfolio $10,000 $38,242 7.12% 9.85% 21.35% -25.59% -36.63% 0.51 0.73 0.98
S&P 500 Total Return $10,000 $48,177 8.40% 15.47% 33.36% -37.00% -50.95% 0.45 0.64 0.99

Eq Curve 2

 

Finally, what is we use a 5 month look back period, like the relative strength tests, instead of 12 months?

Portfolio Initial Balance Final Balance CAGR Std.Dev. Best Year Worst Year Max. Drawdown Sharpe Ratio Sortino Ratio Stock Market Correlation
Timing Portfolio $10,000 $62,456 9.85% 9.72% 33.21% -4.74% -15.38% 0.77 1.22 0.7
Equal Weight Portfolio $10,000 $38,242 7.12% 9.85% 21.35% -25.59% -36.63% 0.51 0.73 0.98
S&P 500 Total Return $10,000 $48,177 8.40% 15.47% 33.36% -37.00% -50.95% 0.45 0.64 0.99

Eq Curve 3

 

The sharpe ratio in all 5 tests ranged from .71 – .80 and in each instance outperformed an equal weight portfolio and the S&P 500.   Investors looking for a simple, momentum based system that avoids “all-in” investments in single asset classes should consider a system using asset allocation funds.

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17 thoughts on “A Diverse Momentum System Using Vanguard Allocation Funds”

  1. Hi,
    In the literature the phenomenon of crashing momentum strategies refers predominently to long-short momentum strategies. Leave out the short side and you will avoid the dreaded crashes. You will still experience drawdowns, though.

    1. Yes, long/short sees the biggest crashes. However, a momentum system which is long 1 singular asset class will also see periods of higher volatility/drawdown. Trend following or absolute momentum can help mitigate those risks.

  2. Hello,

    Interesting article.

    “The first model used a single performance window of 5 months. ”

    Is the performance measure

    (Close of this month/Close of 5 months close ) -1 ?

    Thanks

    1. It was selected at random. However, in other studies momentum periods ranging from 3-12 months have held up reasonably well. The dual momentum 5 month had 73 trades vs 44 for the 12 month dual momentum.

  3. Interesting, but isn’t all the benefit coming from VASIX and VFINX? The others are “tweeners” and, as noted in the original paper, won’t factor if chosen on the basis of momentum (total return) – the “extremes” will be chosen unless risk-adjusted return is used. I don’t see the option to select based on “best Sharpe” at PV.com – or am I missing something? Nice concept.

    1. VASGX is also frequently held. The moderate growth/moderate income funds are rarely held.

  4. Try adding VUSTX to the basket.

    Better still add Mid Cap (MDY or FDVLX) and VUSTX. Every month buy the one based on previous 3 months’ return.
    With MDY VSMGX VASIX VSCGX VASGX VUSTX:

    1996:2015

    CAGR 14%
    Sharpe .93
    Sortino 1.81
    Worst Year 2001 -.8%
    No. of Yearly Losses 2 (2001, and -.4% for 2002).
    $10K becomes $131930.

  5. I like the basket of MDY QQQ EFA TLT with 3 month look back period and monthly updates. This has the advantage that you do not have to have an account at Vanguard.

    2003-2015
    CAGR 19%
    Max DD 15%
    Sharpe 1.15
    Sortino 2.42
    $10K becoms $88K .

    Amazing.

  6. I have done similar studies on Canadian portfolios (BMO ETF Advisor Class) and found similar results. We have the added benefit of tax deferral in corp class funds. Similarly, the middle of the road ones are rarely held — usually growth or fixed income. There is also a money market fund.

    1. I got the best results using 100% stock and 100% bond funds. It looks like If stocks have been strong, then you want to be all in with them. If stocks have been weak, then it’s best not to be in them at all.

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