85% of Large Cap mutual funds are not able to beat the Index. Using this strategy, you can! This is a Do-It-Yourself strategy following the principle of 'Dual Momentum'.
Introduction - How active portfolio management can beat the Index
The objective is to create a portfolio using dual momentum to beat the Indian Index. That means the portfolio will invest in one of the multiple assets chosen based on whichever is doing better. After every fixed period we check again to see which is doing better and reinvest accordingly.
For this case study we take the following 2 assets:
1. Nifty Bees ETF - An exchange traded fund or Equity asset
2. SBI Magnum Gilt fund - A proxy for govt bonds or Debt asset
For example, every fixed period (say 1 month) our model will look at the performance of both funds and choose to invest in one of these. Let's say it invests in Nifty Bees. It will now hold this fund for a month, after which it switch back to Gilt fund or continue based on certain conditions which we will define later.
Why do we choose Nifty 50 ETF and Gilt fund?
Both these asset classes have very a low correlation coefficient (0.07), meaning they are not related to each other. During the equity meltdown time (like 2008 or 2020 crash), their correlation decreases to -0.6. This means that they are inversely related during downturns.
Generally, during an equity meltdown, most asset classes have a positive correlation and that correlation increases. So, this combination provides the required benefit of diversification.
Therefore, we choose Nifty50 ETF and Gilt Fund.
Dual Momentum Strategy:
As mentioned in our earlier posts, dual momentum uses 2 types of momentum. Relative momentum & absolute momentum.
You can read about it here.
Relative momentum gives us the conditions to select the best asset among the given basket over the 'Lookback' period.
Absolute momentum is used to decide the optimal 'Lookback' period and 'Holding' period of the portfolio.
Strategy in action: Jan 2014 to Jun 2020 (78 months)
To decide the portfolio on 1st Jan 2014, we need to look back for a certain period of time & calculate the monthly return of each asset class.
For our example I take 12 months as a Lookback period while ignoring the immediate previous month ie Dec 2013 (to
remove short term noise from the calculation).
You can change the lookback period to optimise it & possibly get a better return. We have taken 11 months only as an example.
So, For the Jan 2014 portfolio construction, we calculate the return from Jan 2013 to Nov 2013 for these two asset classes.
We compare the return of these two asset classes and decide which one to hold for the next month. Whichever asset class has a higher last 11-month return, we invest in that asset class for next month.
We repeat the
same exercise at the end of each month and repeat the same process. Portfolio rebalancing
happens at the end of every month.
For example, In Jan 2014, NiftyBees has a higher relative
return compared to SBI gilt fund, we hold Nifty Bees in our portfolio in
January month. For Feb 2014, if the SBI Magnum Gilt fund has a higher relative return
compared to Nifty Bees, we hold SBI Magnum Gilt Fund in our portfolio in February
at the same time liquidate Nifty Bees from our portfolio.
Principle behind the strategy
This strategy works on the momentum principle. Momentum is the tendency of investments to persist in their performance. Investments that have done well will continue to do well, while those that have done poorly will continue to do poorly.
So, we compare among the selected asset classes and choose the one which has the higher momentum. So, this simple logic is behind the alpha of this strategy.
Result of the strategy
Now let's look at the performance of the Momentum portfolio & compare it with the performance of each individual fund.
We start with Rs 1,000 each.
Year wise return
We end up with Rs 2,384 using the momentum portfolio vs Rs 1,941 using Nifty ETF only and Rs 2,061 using Gilt fund only. That is a 3.5% extra return per year. (forgive the typo in the image)
Notice that there are a couple of years where Nifty Bees returns beats the Momentum Portfolio or is equal to the portfolio. But whenever there is a significant drawdown like in 2015, 2016, 2019 & 2020 the momentum portfolio switches to the SBI gilt fund and remains protected.
Let's also look at how volatile the portfolio was.
Year-wise Volatility: -
- We find that the volatility of our Momentum portfolio is significantly lower than Nifty Bees, though not as low as the SBI Gilt fund.
- Out of 78 months, we had 12 switches in total. And we spent almost equal time in both funds.
- These results will vary depending on the market scenario in the short term but over the longer term (10 years+) we expect the model to follow equity for a longer period than debt.
Conclusion
This is how an actively managed dual momentum-based strategy works. We hope you can create it for yourself & beat the market too!
You can use this to create a momentum portfolio out of any thing, not just Debt + Equity.
We offer momentum portfolio models that invest in equity only. In our case it chooses a top 10 stocks out of 500 stocks on NSE (instead of 1 out of 2 assets like in this case study). If that is something that suits your investment profile or interests you, do reach out to us!
Limitations of the case study:
- Dual momentum strategy doesn't always beat the market year on year and in short term periods there might be a time of underperformance. But because you are investing for a long period then you will get the benefit of avoiding downturns & hopefully beat the index.
- We haven’t considered transaction costs associated with the switches & taxation on profits (short term capital gain vs long term capital gain).
- It is also possible that you will get the benefit of short-term capital loss because you are rebalancing the portfolio each month.
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