Absolute momentum

What Is Absolute Momentum?

Absolute momentum is a quantitative investment strategy within the broader field of portfolio theory that assesses an asset's past performance against a predefined absolute benchmark, typically a risk-free rate or simply zero. Unlike relative momentum, which compares an asset's performance to other assets, absolute momentum focuses on whether an individual asset is exhibiting positive or negative momentum. The primary goal of an absolute momentum strategy is to stay invested in an asset only when it demonstrates positive trends, moving to a defensive asset like cash or short-term bonds when its momentum turns negative. This approach is primarily used for risk management and capital preservation, aiming to avoid significant drawdowns during prolonged market downturns.

History and Origin

The concept of absolute momentum is deeply intertwined with the development of quantitative and trend following strategies. While the underlying principle of following trends has existed for centuries, its formalization into systematic investment approaches gained traction in modern finance. Meb Faber's 2007 paper, "A Quantitative Approach to Tactical Asset Allocation," is a significant work that popularized a rule-based system involving a 10-month moving average to determine whether to be invested in a particular asset class or move to cash. This methodology laid a strong foundation for what is now widely understood as absolute momentum.⁹, ¹⁰, ¹¹ The paper demonstrated that applying a simple quantitative method could improve risk-adjusted returns across various asset classes by avoiding large losses.⁸ Gary Antonacci further developed and popularized the "Dual Momentum" strategy, which combines both absolute and relative momentum rules to manage portfolios dynamically.

Key Takeaways

• Absolute momentum assesses an asset's performance against an absolute standard, often cash or zero.
• The strategy aims to remain invested in assets with positive momentum and exit to defensive positions during negative trends.
• Its primary benefit lies in potential capital preservation and drawdown reduction during bear markets.
• Absolute momentum is a core component of many tactical asset allocation and quantitative strategies.
• It seeks to improve risk-adjusted returns by avoiding prolonged exposure to declining assets.

Formula and Calculation

The calculation for absolute momentum typically involves measuring an asset's total return over a specific look-back period and comparing it to a threshold. A common approach uses the asset's past 12-month total return compared to the return of a short-term U.S. Treasury bill (often approximated as the risk-free rate) or simply zero percent.

The formula can be expressed as:

Where:

• ( R_A ) = Total return of the asset over a defined look-back period (e.g., 12 months).
• ( R_B ) = Benchmark return over the same period (e.g., U.S. Treasury bill return or 0%).

If the asset's return ( R_A ) exceeds the benchmark return ( R_B ), the signal is to "BUY" or remain invested. If ( R_A ) is less than or equal to ( R_B ), the signal is to "SELL" and move to a defensive asset.

Interpreting the Absolute Momentum

Interpreting the absolute momentum signal is straightforward: a positive signal (asset return > benchmark) suggests the asset is in an uptrend and suitable for holding, while a negative signal (asset return ≤ benchmark) indicates a downtrend, warranting a move to a defensive position. This binary decision rule simplifies market timing by focusing on whether an asset is generating positive returns above a minimal hurdle, rather than trying to pick the "best" performing asset. The core idea is to participate in upward trends in the financial markets while avoiding significant losses during sustained declines, thereby protecting capital.

Hypothetical Example

Consider an investor using an absolute momentum strategy with a 12-month look-back period, comparing the total return of an equity index to a 0% benchmark (i.e., simply checking if the return is positive).

• Month 1: The S&P 500's total return over the past 12 months is +15%. Since +15% > 0%, the absolute momentum signal is "BUY." The investor remains invested in the S&P 500.
• Month 7: The S&P 500's total return over the past 12 months is -5%. Since -5% ≤ 0%, the absolute momentum signal is "SELL." The investor moves their capital from the S&P 500 to cash.
• Month 15: The S&P 500's total return over the past 12 months is +8%. Since +8% > 0%, the absolute momentum signal is "BUY." The investor re-enters the S&P 500.

This step-by-step process demonstrates how absolute momentum helps an investor navigate market cycles, aiming to capture gains and mitigate losses by reacting to an asset's own trend.

Practical Applications

Absolute momentum is a foundational concept in various systematic investment strategies. It is widely applied in:

• Tactical Asset Allocation: Investors and fund managers use absolute momentum to dynamically adjust their exposure to different asset classes (e.g., stocks, bonds, commodities) based on their individual momentum signals. If a particular asset class shows negative absolute momentum, capital is reallocated to a safer asset, rather than staying invested or moving to another risky asset.
• Portfolio Construction: Incorporating absolute momentum rules can help build more resilient portfolios by systematically reducing exposure to falling markets, thereby enhancing diversification and managing overall portfolio risk.
• Trend Following Systems: Absolute momentum forms the basis of many trend-following strategies, which seek to profit from sustained price movements in securities or markets. These systems often employ various look-back periods and benchmarks to generate buy or sell signals. Research Affiliates, for instance, emphasizes how factors like momentum play a role in optimizing multi-factor portfolios, suggesting that combining momentum with other factors can improve risk-adjusted returns and even reduce trading costs due to offsetting trades.
• ⁵, ⁶, ⁷ Risk Overlay Strategies: Financial institutions may use absolute momentum as a risk overlay, a separate layer of management designed to protect a portfolio from large drawdowns without fundamentally altering its long-term strategic asset allocation.
• Behavioral Finance Context: The existence and effectiveness of momentum strategies are often discussed in the context of behavioral finance, which posits that market inefficiencies can arise from investor biases, creating persistent trends that momentum strategies can exploit.

##⁴ Limitations and Criticisms

While absolute momentum offers benefits in risk management and capital preservation, it is not without limitations:

• Whipsaws: Absolute momentum strategies can be prone to "whipsaws" in volatile, directionless markets. If an asset's performance hovers around the benchmark, it may generate frequent buy and sell signals, leading to excessive trading costs and potentially missing out on short-lived rallies or incurring losses from false signals.
• Lagging Indicator: As absolute momentum relies on historical data (a look-back period), it is inherently a lagging indicator. It reacts to trends once they are established, meaning it may miss the very beginning of a new uptrend or the very top of a downtrend.
• Momentum Crashes: Historically, there have been periods, known as "momentum crashes," where the momentum factor has experienced sharp, sudden reversals, leading to significant losses for strategies heavily reliant on it. A notable instance occurred in September 2020, where quantitative funds experienced a "momentum crash" as past winners underperformed and past underperformers surged, stinging many quant funds. Suc², ³h events highlight the vulnerability of momentum strategies to unexpected shifts in market dynamics.
• ¹ Suboptimal in Strong Bull Markets: In a continuous strong bull market, absolute momentum may cause an investor to exit a profitable position prematurely if there's a temporary dip that triggers a "SELL" signal, thus underperforming a simple buy-and-hold strategy during such periods.
• Data Snooping/Overfitting: As with many quantitative strategies, there's a risk of data snooping or overfitting during the development phase, where rules might be tailored to past data, leading to poorer performance in real-world applications.

Absolute Momentum vs. Relative Momentum

Absolute momentum and relative momentum are distinct yet often complementary concepts within momentum investing strategies. The key difference lies in their reference point for evaluating performance:

While absolute momentum aims to avoid losing money by stepping aside when an asset falters, relative momentum seeks to generate alpha by continually rotating into the strongest performers within a defined universe. Many advanced momentum systems, such as dual momentum, combine both types of analysis to create a robust investment strategy that seeks both capital preservation and enhanced returns.

FAQs

What is the main purpose of absolute momentum?

The main purpose of absolute momentum is to protect capital and reduce large losses during market downturns. It does this by signaling when to exit a declining asset and move to a safer alternative, such as cash.

How does absolute momentum help in risk management?

Absolute momentum aids risk management by providing a systematic rule to reduce exposure to assets experiencing negative trends. This can help investors avoid significant drawdowns that occur when assets are held through prolonged declines.

Can absolute momentum be used for all types of investments?

Absolute momentum can be applied to various liquid investments, including equity indices, bonds, commodities, and even individual stocks. However, its effectiveness can vary depending on the asset class and market conditions.

Is absolute momentum a form of market timing?

Yes, absolute momentum is considered a form of market timing because it involves making decisions to enter or exit markets based on quantitative signals derived from past price action. However, it's a systematic approach rather than discretionary market timing.

How often should absolute momentum signals be checked?

The frequency for checking absolute momentum signals varies but is typically done monthly. This helps avoid excessive trading (whipsaws) that could result from reacting to short-term market noise.