Applying relative momentum helps to rotate in those assets that perform best at the time. Using new methods and evidence in momentum investing, allowed us to mitigate the disadvantages of the original strategy.

Historically, small-cap stocks have outperformed large-cap stocks. However, this performance varies over time and is based on the broader economic environment. Small-caps fared well between the change of the millennium and the great financial crisis in 2008. Before the change of the millennium and after the great financial crisis (and still to-date), large-caps outperform small-caps. Determining when a regime changed and a new trend started is a classic application of momentum investing methods. However, the results of a first attempt by Gary Antonacci for a cross-asset approach didn’t warrant a style-oriented momentum strategy. Applying new methods like introducing a canary asset or using various fixed income durations for defensive assets allowed us to mitigate the disadvantages of the original strategy and increase returns by 500 basis points.

Our Style Rotation strategy uses US Treasury Inflation-Protected Securities (TIPS) as a canary asset to determine when to allocate offensive or defensive assets. The strategy is to invest in offensive investment-style assets as long as TIPS shows positive momentum. When TIPS drop into negative momentum territory, the strategy rotates into defensive fixed income assets.

When shifting to a defensive risk posture, most strategies blindly dump the portfolio into fixed income assets regardless of how bonds perform. This flaw was exposed in 2022 when risk assets and bonds fell simultaneously. With Style Rotation we take an alternative approach. Using a canary asset, Style Rotation consists of two universes, an offensive and a defensive. We apply the same momentum rules to defensive assets as for holding offensive assets. If the defensive assets fail the momentum rule (e.g. they also display negative momentum), the strategy will allocate to cash instead.

This is a novel approach to fend off the threat of rising interest rates and its negative impact on fixed income. If the strategy calls for a defensive approach, the momentum rules will automatically rotate into the fixed income asset with the highest momentum. If interest rates rise, shorter-term treasuries will likely display positive momentum. In contrast, the rules will likely rotate into long-term treasuries in a deflationary environment.

Lastly, using various look-back periods for the momentum score calculations helps confirm lasting trends over sharp short-term moves in one direction, only to reverse in the opposite direction quickly and therefore potentially producing false signals.

Style Rotation is one of our highest performing strategies. However, it bears the added risk of allocating 100% to a single risk asset. For this reason, we use appropriate caution and only use this strategy as an add-on strategy in combination with our core strategies.