Momentum is everywhere, including government bonds

(MoneyWatch) There is a vast body of evidence demonstrating that stock returns exhibit momentum -- that is, stocks that have done well over the past year tend to continue to do well. And there's evidence that the momentum premium exists almost everywhere we look, in both U.S. and international stocks (with the notable exception of Japan). There's also academic research demonstrating that momentum exists in commodity and foreign exchange markets as well.

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The authors of the 2012 paper, "Momentum in Government-Bond Markets," studied the period 1987-2011 to determine if momentum existed in these assets. For six countries -- Australia, Canada, Germany, Japan, the U.K., and the U.S -- they formed long-short portfolios, going long a particular bond maturity if the excess return of the bonds over cash was positive for the previous month and shorting otherwise. For each country they considered three maturity buckets: 1-3 years, 5-7 years and 7-10 years. They subtracted the LIBOR cash return to arrive at the "excess" return. Rebalancing was done monthly. The strategy is easily implementable using highly liquid futures markets. The benchmark is the currency-hedged Citigroup World Government Bond Index. The following is a summary of their findings:

• Momentum strategies are profitable, generating annual excess returns over LIBOR of between 0.70 and 2.6 percent, and they do so with low volatility (1 percent to 3.6 percent).
• Australia, with the least liquid of the six markets studied, exhibited the lowest returns to momentum strategies. The three most liquid markets -- U.S., Japan and Germany --are the best for momentum strategies. Thus, greater liquidity doesn't seem detrimental to momentum strategies (and trading costs are the lowest in the most liquid markets).
• The strategy doesn't rely on falling interest rates. However, "choppy" markets without direction are detrimental to performance, and returns can be episodic.
• The excess profits generated are more than sufficient to cover transactions costs as the government bond markets are very liquid.
• Momentum returns are particularly strong during periods of poor performance for credit markets. Thus, momentum strategies provide some diversification benefit against bond strategies that seek exposure to credit (default) risk.

The authors tested the diversification benefits by combining a 20 percent momentum strategy with an 80 percent Barclays Capital U.S. Aggregate Bond Index allocation, with monthly rebalancing. The simulated portfolio generated excess returns of 0.35 percent a year while reducing volatility -- the standard deviation fell 0.40 percent. Investors who take credit risk in their bond allocations should consider adding a momentum strategy.

This diversification benefited provided by momentum strategies also applies to investors in value stocks. Because momentum is negatively correlated with the value premium, adding momentum to a value-tilted portfolio improves risk-adjusted returns.

While there is a logical risk-based explanation for the existence of the stock, small-cap and value-stock premiums, there is none for momentum -- only a behavioral story. Yet, despite the fact that there is no risk-based explanation and that the existence of momentum has been known for decades (thus it would seem that it should have been arbitraged away), momentum persists virtually everywhere we look.

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