In the past 40 years, stocks and bonds have been an unbeatable portfolio. But that hasn’t always been true. Throughout history, periods of positive correlation between stocks and bonds are common. And we have seen that in recent years firsthand. But developing strategies that incorporate other asset classes can be difficult since many of the alternatives do not perform as well as stocks and bonds on a buy and hold basis. So a different approach is needed. That is where Keurig and Keller’s generalized protective momentum (GPM) strategy comes in. The strategy is one of the series of quantitative asset allocation strategies we feature on Validea and uses momentum to build a multi-asset portfolio with very interesting risk and return characteristics.

Goal of the Strategy

The primary objective of Keurig and Keller’s GPM strategy is to create a portfolio that can generate consistent returns across various market conditions while simultaneously protecting against significant drawdowns. By combining momentum-based asset selection with a dynamic allocation to protective assets, the strategy seeks to capture upside potential in rising markets while providing downside protection during market turbulence.

Detailed Criteria and Asset Selection

The GPM strategy employs a systematic approach to asset selection and portfolio construction, utilizing a diverse set of asset classes and specific criteria to determine optimal allocations. The strategy considers the following asset classes:

1. Equities: US large-cap stocks, US small-cap stocks, and international developed and emerging market stocks
2. Fixed Income: US Treasury bonds, corporate bonds and high yield bonds.
3. Other Asset Classes: Gold, Commodities and Real Estate
4. Cash: Short-term Treasury bills or money market instruments

The strategy’s asset selection process involves two key steps:

1. Momentum: The strategy calculates the momentum of each asset in the selection universe and also looks at the correlation of each asset with the asset classes as a whole. The three assets with the highest score across these two metrics are included in the portfolio. By using correlation in addition to momentum, the strategy reduces drawdowns since it is more likely to include assets that are not correlated with each other.
2. Crash protection: As the number of assets that achieve negative scores using the strategies scoring system rises, the portfolio will move into a crash protection asset. This asset is either short-term or intermediate-term treasuries depending on which of the two has more momentum. If half the assets in the selection universe have negative scores using its system, it will move 100% into the crash protection asset. This helps to limit risk during major market events.

Long-Term Performance

Keurig and Keller’s research, as detailed in their paper, demonstrates the GPM strategy’s impressive long-term performance. The authors backtested the strategy over several decades, comparing its results to traditional asset allocation approaches and market benchmarks.

Key findings from their performance analysis include:

1. Superior Risk-Adjusted Returns: The GPM strategy outperformed traditional 60/40 stock/bond portfolios and market-cap-weighted indices on a risk-adjusted basis, as measured by the Sharpe ratio.
2. Reduced Volatility: The strategy exhibited lower overall volatility compared to stock and bond portfolios, thanks to its dynamic allocation to protective assets.
3. Improved Downside Protection: During significant market drawdowns, the GPM strategy demonstrated its ability to limit losses more effectively than traditional allocation strategies.
4. Consistent Performance Across Market Cycles: The strategy showed resilience across various market environments, including bull markets, bear markets, and periods of economic uncertainty.

Managing Drawdowns and Reducing Volatility

One of the most notable aspects of the GPM strategy is its ability to manage drawdowns and reduce overall portfolio volatility. This is achieved through several key mechanisms:

1. Dynamic Asset Allocation: By continuously reassessing momentum and adjusting allocations, the strategy can quickly adapt to changing market conditions. This allows it to reduce exposure to underperforming assets and increase allocation to assets with positive momentum.
2. Inclusion of Protective Asset: The inclusion of a protective asset provides a hedge against equity market downturns.
3. Equal-Weight Approach: By equally weighting the selected assets, the strategy inherently limits concentration risk and promotes diversification. This can help smooth out returns and reduce the impact of any single asset’s poor performance.
4. Trend-Following Characteristics: The momentum-based selection process tends to keep the portfolio aligned with prevailing market trends. This can help the strategy exit declining assets before significant losses accrue and maintain exposure to assets in uptrends.
5. Risk Parity Principles: While not explicitly a risk parity strategy, the GPM approach incorporates some risk parity principles by balancing exposure across assets with different risk characteristics. This can lead to more stable overall portfolio volatility.

As the investment landscape continues to evolve, strategies like GPM that focus on adaptive asset allocation and downside protection are likely to remain relevant. By offering a systematic approach to navigating complex market environments, it can be an interesting strategy for investors seeking to manage drawdowns and risk in different market environments.

Research Links

Validea’s Generalized Protective Momentum Strategy