The lack of true downside protection has long been a concern for those using SMI’s Fund Upgrading strategy. Fortunately, recent developments in the study of momentum have laid the foundation for a new defensive protocol that provides a “safety net” for Upgrading.
This new 2.0 protocol gives us confidence that Upgrading will be up to the task of defending member portfolios during the next bear market.
SMI’s Fund Upgrading strategy, which uses a concept known as “performance momentum” to make investment recommendations, has been part of the SMI newsletter in some form or fashion from its earliest days in 1990. By the late 1990s, Upgrading had settled into roughly the form used today. In the years since, the only significant change to Upgrading, at least on the stock-fund side, has been the switch from recommending four funds in each risk category to only three (in April 2015).
In the meantime, academic and industry research on the momentum principles on which Upgrading is based has been anything but idle. In fact, momentum has been one of the most heavily researched investing topics for several decades now. This is largely due to its status as “the premier market anomaly.” Momentum is an easily observable exception to the conventional wisdom that stock market prices are set by such an efficient process that it’s difficult — if not impossible — for investors to outperform the market over time.
That “premier anomaly” label was attached by none other than Eugene Fama, who won a Nobel prize for his work on the Efficient Market Hypothesis. As the name implies, his life’s work has been explaining why factors such as momentum shouldn’t work. Yet just this past year, Fama conceded, “Momentum is a big embarrassment for market efficiency.”
Because momentum has been such a persistent thumb in the eye of the indexing/efficient markets community, researchers have undertaken many studies of momentum. Actually, the earliest such research dates back nearly a century, but up until about a decade ago, most of the research focused on variations of relative momentum — i.e., how an investment has performed relative to others. This relative-momentum analysis is the type SMI has always used in SMI’s Upgrading strategy, and is reflected in our monthly Fund Performance Rankings report.
While the research studies on relative momentum affirmed its robustness and effectiveness, it wasn’t until somewhat recently that a new momentum idea emerged. This was the study of how an investment performed, not against other investments, but against its own past. This second type of momentum is referred to as absolute momentum. Relative momentum asks the question: “In recent months, how has this investment performed compared to others?” But this newer momentum measure asks the question: “In recent months, how has the investment performed in an absolute sense, looking at its own history, ignoring what others have done?”
Multiple studies have confirmed that asking this question can lead to profitable investing choices going forward, but credit for popularizing absolute momentum belongs to Gary Antonacci, who detailed it extensively in his award-winning book, Dual Momentum Investing. In addition to compiling the results of all the research done on absolute momentum, much of it his own, Antonacci also took the crucial step of marrying the two forms of momentum — relative and absolute — into a simple investment strategy that readers of his book could apply easily. The backtested results of this approach were surprisingly good, despite the approach being extremely simple.
In a nutshell, while Antonacci demonstrated what SMI Upgraders have long known, that relative momentum can be a powerful return enhancer, he added a critical new dimension as well: showing how applying absolute momentum criteria could limit downside loss significantly.