Author: shyam

Book Review: The Dictator’s Handbook

In the book, The Dictator’s Handbook: Why Bad Behavior is Almost Always Good Politics (Amazon,) authors Bruce Bueno de Mesquita and Alastair Smith systematically present the idea that whether it be an autocracy, a democracy or something in between, leaders do whatever keeps them in power, regardless of the national interest.

From the book:
Our starting point is the realization that any leader worth her salt wants as much power as she can get, and to keep it for as long as possible.

Paying supporters, not good governance or representing the general will, is the essence of ruling.

In politics, coming to power is never about doing the right thing. It is always about doing what is expedient.

Having competent ministers, or competent corporate board members, can be a dangerous mistake. Competent people, after all, are potential (and potentially competent) rivals.

The three most important characteristics of a coalition are: (1) Loyalty; (2) Loyalty; (3) Loyalty. Successful leaders surround themselves with trusted friends and family, and rid themselves of any ambitious supporters.

Recommendation: Worth a read. Or, you could just watch this video instead:

Global Equities Momentum

Gary Antonacci created the Global Equities Momentum (GEM) model that applied dual momentum to stock and bond indices. It toggles between stocks and bonds using 12-month trailing returns. And when it toggles to “stocks,” it chooses between US equities and International (ex-US) equities based on whichever posted higher returns in the previous 12-months. Newfound Research has a chart that puts it across succinctly:

The model uses the S&P 500 index as a stand-in for US equities and the WORLD ex USA index for international stocks. However, there is nothing in the construction that prevents us from replacing those market-cap based indices with momentum based ones.

US Momentum / Market-cap International

Scenario 1: keep everything the same, except in the last stage, instead of buying S&P 500, buy US Momentum (SP 500×1).
Scenario 2: swap out S&P 500 and put US Momentum everywhere in the decision tree (MOM).

In the cumulative return chart below, the black line is the base case. It represents GEM as originally designed. The red line is Scenario 1 above, green is Scenario 2.
sp500.mom.GEM.cumulative

Even though Scenario 2 has higher returns, it comes at the cost of higher drawdowns. Scenario 1 seems to strike a compromise.
Base case drawdowns:
SP500.GEM.dd
Scenario 1 drawdowns:
SP500x.GEM.dd
Scenario 2 drawdowns:
MTUM.GEM.dd

US Momentum / International Momentum

What if, we bought International Momentum (WORLD ex USA MOMENTUM) instead of the market-cap based WORLD ex USA?
Scenario 3 (dark blue): keep everything the same, except in the last stage, instead of buying S&P 500, buy US Momentum. And instead of buying market-cap international, buy WORLD ex USA MOMENTUM (SP 500×2).
Scenario 4 (light blue): swap out S&P 500 and put US Momentum everywhere. And instead of buying market-cap international, buy WORLD ex USA MOMENTUM (MOMx2).

sp500.mom.world.GEM.cumulative

Scenario 3 drawdowns:
SP500x2.GEM.dd
Scenario 4 drawdowns:
MTUMx2.GEM.dd

Here are returns broken down annually for all the scenarios discussed above:
sp500.mtum.x2.GEM.annual

It appears that using the S&P 500 index for making decisions about buying US vs. World ex-US momentum boosts returns while keeping a floor under drawdowns.

Code and charts are on github.

MSCI USA Momentum Index

In our previous post, Momentum: Peek under the hood before you invest, we compared a couple of momentum ETFs listed in the US. The most popular one, MTUM, was launched in April 2013. For an investor who is considering it, a five-year sample size is hardly enough. Thankfully, the ETF tracks the MSCI USA Momentum Index. And even though the index itself was launched in February 2013, MSCI has back-filled index levels going back from 1975.

USA Momentum vs. S&P 500 Annual Returns

msci-usa-mom.sp500.annual

USA Momentum vs. S&P 500 Cumulative Returns

msci-usa-mom.sp500.cumulative

It looks like the Momentum Index is highly correlated with the S&P 500 index and for a little bit more volatility, investors end up with quite a bit of excess returns. Does it make sense to swap out the staid old market-cap weighted SPY with MTUM?

How long is long term?

Most new equity investors think “long term” is three years. Some think its five. This leads to expectations that are setup to fail. We wrote about projecting future returns recently where we showed how we expect 20-year returns to be statistically distributed. In the simulations that we ran for that article, we also projected returns for 10- and 30-year horizons. We reproduce the charts below.

10-year S&P 500 return distribution

SP500.GLD 10-year

20-year S&P 500 return distribution

SP500.GLD 20-year

30-year S&P 500 return distribution

SP500.GLD 30-year

As your investment horizon grows larger, the probability of you facing severe losses come down and the overall probability of positive outcomes increase.

Fama and French agree

In a recent paper, Volatility Lessons for the Financial Analysts Journal, Eugene F. Fama and Kenneth R. French pretty much arrive at the same result. Here are the charts from their paper:

And they conclude:

The high volatility of monthly stock returns and premiums means that for the three- and five-year periods used by many professional investors to evaluate asset allocations, the probabilities that premiums are negative on a purely chance basis are substantial, and they are nontrivial even for 10- and 20-year periods.

Basically, long-term is ~30 years, anything less that is prone to be influenced by noise (luck.)