### Tactical, Simplified, Long-only MPT with Momentum

**January 22, 2014** - Momentum Investing, Strategic Allocation

Is there a tractable way to combine momentum investing with Modern Portfolio Theory (MPT)? In their December 2013 paper entitled “Tactical MPT and Momentum: the Modern Asset Allocation (MAA)”, Wouter Keller and Hugo van Putten present a tactical, simplified, long-only version of MPT that applies momentum to estimate future asset returns. Specifically, they:

- Make MPT tactical by using short historical intervals to estimate future asset returns (rate of return, or absolute momentum), return volatilities (based on daily returns) and return correlations (based on daily returns), assuming that behaviors over a short historical interval will materially persist during the next month.
- Exclude from the portfolio any assets with negative estimated returns (i.e., negative returns over the specified historical interval).
- Simplify correlation calculations by relating daily historical returns for each asset to those for a single index (the equally weighted average returns for all assets) rather than to those for all other assets separately.
- Dampen any errors in rapidly changing asset return, volatility and correlation estimates by “shrinking” them toward their respective averages across all assets in the universe, and dampen the predicted market volatility by “shrinking” it toward zero.

They reform the MAA portfolio monthly at the first close. Their baseline historical interval for estimation of all variables is four months (84 trading days). Their baseline shrinkage factor for all variables is 50%. Their benchmark is the equally weighted (EW) “market” of all assets, rebalanced monthly. They assume a one-way trading friction of 0.1%. They consider a range of portfolio performance metrics: annualized return, annual volatility, maximum drawdown, Sharpe ratio, Omega ratio and Calmar ratio. Using daily dividend-adjusted prices for assets allocated to nine universes (of seven to 130 assets, generally consisting of asset class proxy funds) during November 1997 through mid-November 2013, *they find that:* Keep Reading