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The surprisingly strong case for index roulette

The financial life of a prudent index investor is purposefully dull. You know the routine. Pick a balanced portfolio of basic low-fee funds and ETFs, rebalance occasionally, and hope to wake up comfortably rich one day.

Where's the spark in that? Where's the pizzazz? Where are the piles of doubloons? To become stinking rich, you have to strap on the six shooters and shoot for higher targets.

Cue the normal caveats: This ratchets up your risk. It is not for everyone. It could leave you poor.

But that being said, let's take a look at a risky but potentially profitable way to amp up the returns from index investing.

Instead of spreading your bets around, we'll examine what would have happened over the past four decades if you had used momentum trends to pick where to invest among six basic asset classes: three-month Canadian treasury bills, long-term Canadian bonds, the S&P/TSX composite, the S&P 500, international stocks (via the EAFE index), and gold.

A sensible investor who invested equal parts of their portfolio in each asset would have netted a handy average annual return of 10.4 per cent since 1971. But those with more derring-do might have opted to buy the asset class that had fared the best over the prior year. Those brave souls would have nabbed an 18.6-per-cent average annual return.

On the other hand, contrarian investors, who bought into whatever happened to be the worst class over the prior year, would be crying in the poor house with returns of only 5.7 per cent a year. The path taken by each of these investors is displayed in the accompanying graph. (It shows results in Canadian dollars before fees are subtracted and assumes annual rebalancing.)

Asset class momentum returns
[larger version]


Rather surprisingly, momentum still wins by a mile even if you exclude any one of the six asset classes from the mix. (Mind you, ignoring gold reduces overall returns rather substantially because gold saw some very nice runs in the 1970s and 2000s.)

The time spent at the top of the heap is shown in the accompanying bar chart. As you might expect, the top-performing asset class was most often dethroned by a new one after only one year. Such periods are collected up into the one-year category. It's the relatively high number of two-, three-, and four-year streaks that make the momentum strategy shine. They put momentum investors in the best asset class about 34 per cent of the time. Even better, the largest down period for momentum was a decline of only 5.6 per cent back in the early 1980s when it erred by moving into the S&P 500.

Momentum streaks
[larger version]


So should you unleash your inner Yosemite Sam and try to reach for better returns using a concentrated momentum approach? It's hard to endorse such a scheme because these methods tend to eventually blow up like old barrels of TNT. But if you want to lean a bit in this direction, a little birdie told me that long bonds are the place to be in 2012.

First published in the Globe and Mail, March 10 2012.

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