While index funds are gaining acceptance among informed Indian investors, it is always interesting to test out certain rule-based investment strategies and how those strategies have fared against simple portfolios. Rule-based strategies can eliminate human biases, or so I hope.
In this post, we compare the performance of the following 4 portfolios over the last 18 years and test a momentum investing strategy.
- Nifty Total Return Index (Nifty TRI)
- HDFC Liquid Fund
- 50% Nifty 50 + 50% HDFC Liquid Fund (Rebalanced Annually on January 1)
- Nifty 50 and HDFC Liquid (Momentum Strategy)
How does the Momentum Strategy (Nifty 50 and Liquid Fund) work?
On 1st of every month, we consider past 1-year returns of Nifty 50 and HDFC Liquid Fund.
If Nifty 50 1-year return > HDFC Liquid 1-year return ==> 100% portfolio in Nifty 50
If Nifty 50 1-year return < HDFC Liquid 1-year return ==> 100% portfolio in HDFC Liquid Fund
Therefore, every month we are either fully invested in Nifty or in the liquid fund.
Contrast this with the Nifty and Liquid (50:50) rebalanced portfolio, where we always have both Nifty and liquid fund in the portfolio. On 1st of January every year, the portfolio is rebalanced to 50:50.
I do not want to go into details of momentum investing. I don’t think I will do a good job either. If you are interested in momentum investing, I recommend you read the two awesome books mentioned at the end of this post. Momentum can be used in many ways (relative momentum and absolute momentum). You can also use momentum strategies to select a portfolio of stocks. I have used in the manner described above.
The basis of momentum investing is: Once an asset starts falling, it keeps falling for some time. Once it starts rising, it keeps rising for some time. By using momentum in our investment approach, we hope that we will be able to get out of a falling asset soon. At the same time, we will be able to get on the rising asset soon. This will hopefully capture the upside and reduce the drawdowns.
What does the data tell us?
We had Nifty data from June 1999 and HDFC liquid data from October 2000. Since we needed 1-year performance data for the momentum strategy, the plot/performance comparison starts from October 2001.
Nifty 50 has been the best performer over the last 18 years. Not surprising since the Nifty has risen sharply at a CAGR of 14.5% p.a. from October 2001 to May 2020. HDFC Liquid has given CAGR of 7.1% p.a.
Momentum portfolio gives a CAGR of 12.54% p.a. 50:50 portfolio gives a CAGR of 12.07% p.a. Hence, the momentum strategy beats the 50:50 Nifty and Liquid fund portfolio marginally.
The above chart tells us something else too. The bulk of the outperformance comes in the first decade (until the end of 2010). We discuss this later.
Additionally, notice the volatility in the valuation. While Nifty 50 portfolio is all over the place. 50:50 portfolio shows relatively steady growth. The Momentum portfolio is somewhere in between in terms of volatility. For the data under consideration, portfolio rebalancing has reduced volatility but has not given higher returns.
Rolling returns give a similar conclusion.
This is important. Both the Momentum Strategy and the 50:50 portfolio have lower drawdowns compared to Nifty. For Nifty, the maximum drawdown is 59.5%. For 50:50 portfolio, the maximum drawdown is 26.7%. For the momentum portfolio, the maximum drawdown is 35.5%.
Which is better? 50:50 portfolio or Momentum portfolio?
The results of the momentum portfolio are not very impressive, at least for this set of data.
Although the returns for the entire duration are higher than the 50:50 portfolio, these have come at a higher volatility, as is evident from rolling returns chart and P2P returns chart. Moreover, the outperformance has come only in the first nine years. In this decade, this momentum portfolio has underperformed the 50:50 portfolio badly. You can just look at the rolling returns chart for this decade. The 50:50 portfolio has beaten the momentum portfolio almost every time.
Therefore, if you had gotten into momentum strategy in 2011 looking at the performance of the strategy in the previous decade, you would have been thoroughly disappointed. While the momentum strategy beat the 50:50 portfolio in 7 out of 9 full years in the previous decade, it has lagged 50:50 portfolio in 6 out of 9 full years in this decade.
The 50:50 portfolio is easier to manage. You just have to transact once every year and then forget about it until next year.
The Momentum portfolio, by its construct, will entail more transactions, resulting in higher transaction costs and potentially higher capital gains. But I might be overplaying this. Since we work with past 1-year returns, the churn will not be that high either. For instance, over the last 19 years, the Momentum portfolio would have to rebalanced (tweaked) only 26 times. You would have touched 50:50 portfolio 19 times. At the same time, we are missing a point. Momentum portfolio goes all in or all out when it changes. You must buy and sell big amounts. A 50:50 portfolio just has to be rebalanced (may not require you to sell big amounts).
While the momentum portfolio protects the downside by moving to liquid funds after an initial fall, it can also be late to the party during an upswing, especially if the rise is sudden.
For instance, during the financial crisis, the momentum portfolio exited Nifty in July 2008, The Nifty fell a further 36% (since the Momentum portfolio exit from Nifty) and formed a bottom in March 2009. The Nifty bounced back sharply from March 2009 lows. Momentum got back into Nifty only in June 2009. From March 2009 lows, the Nifty had jumped 73% before Momentum portfolio got back into Nifty.
And, there is where the investor behaviour comes in. No strategy, no matter how good, will work if you can’t stick to it. We get uncomfortable if we are making less or losing more than our colleagues, neighbours and even the market. Here is the matrix.
Everybody else is losing money. We are losing money. (We are OK).
Everybody else is losing money. We are not losing money. (We are OK)
Everybody else is making money. We are making money. (We are OK)
Everybody else is making money. We are not making money. (We are NOT OK. We might shun strategy at the wrong time).
It is uncomfortable sitting on the fence for your system to throw up a Buy signal while everybody else is making money. Something you would have experienced in the momentum strategy when the markets bounced from financial crisis lows. You will cave in sooner or later, perhaps at the worst time. And this is applicable to any active strategy.
By the way, for the recent fall in markets due to the Covid-19 crisis, the momentum strategy went into 100% liquid fund at the end of February. As at the end of May, it was still 100% in liquid fund. Time will tell if this will pay off.
With a 50:50 portfolio, you have a certain portion of your money which will keep rising with the markets. It is easier to stick to such a strategy.
That the momentum strategy does not work very well for these two assets and for the period under consideration does not mean the results will be bad for other assets too. Over the next few weeks and months, I shall throw other assets in the mix (say gold, international equity) and see how the momentum strategy fares. The only problem is that we have limited ETF/MF history for assets other than for equity and debt. We shall see.
Does Gold make sense in the Momentum Strategy? (Anoop Vijaykumar from CapitalMind)