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, Buckingham (105 clicks)
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Summary

  • When momentum experiences occasional crashes, it’s the short side that causes the losses.
  • It’s also important to understand that all premiums are volatile, with their volatility being a multiple of the premium itself.
  • In bear markets, forced selling by margin calls can lead to momentum, as can short squeezes in bull markets.

Today concludes a two-part series on myths about momentum. We'll pick up right where we left off with the additional myths the paper "Fact, Fiction and Momentum Investing" discusses.

Myth #6: Momentum is best used with screens rather than as a direct factor

Besides presenting their logic for why the myth is false, the authors cite the 2013 study "A New Core Equity Paradigm" by Frazzini, Israel, Moskowitz and Novy-Marx that found a factor-based approach for momentum is superior to a screen-based approach. The one thing I would add to their comments is something the authors themselves note in their discussion on Myth 8. When momentum experiences an occasional crash because markets undergo major reversals (as it did in 2009), it's the short side that causes the losses while the long side of momentum continues to perform well. Screening out negative momentum helps avoid momentum crashes.

Myth #7: One should be particularly worried about momentum's returns disappearing

Despite having the longest track record and the largest premium, the reason for this concern is that there really isn't much of a risk story behind the premium. It's basically a behavioral story. Of course, there's been a great debate for about 20 years now on whether the value premium is a behavioral story or a risk story (or perhaps some of both). The problem for a behavioral driven premium is that once discovered arbitrage forces may eventually eliminate it. The authors note that while this is, of course, possible, "it's far from certain, and a risk-based factor can also disappear if tastes for risk change or the price of risk changes (even supporters of a pure risk-based story readily admit that the price of risk can and does change substantially through time)." The authors also note that there's really no evidence that in the 20 years since publication the momentum premium has disappeared. They also note, importantly, that even if the momentum premium was zero, for value investors, the diversification benefits would still make momentum a valuable tool.

Myth #8: Momentum is too volatile to rely on

This is really just another version of the sporadic myth and since volatility is fully accounted for in momentum's reported Sharpe ratios, it's just as false. It's also important to understand that all premiums are volatile, with their volatility being a multiple of the premium itself. For example, while the beta premium has been about 8 percent, its standard deviation has been about 20 percent. The momentum premium has also been about 8 percent, but its standard deviation has been lower at about 16 percent. And while the size and value premiums have been about 3 percent and 5 percent, respectively, their standard deviations have each been about 13.

Another important point made by the authors is that while the momentum premium is volatile, when combined with a value strategy, the worst case losses are reduced. And the impact on the overall portfolio is all that matters.

Myth #9: Different measures of momentum can give different results over a given period!

The fact that different measures can give different results is true with any strategy. For example, the different value measures such as earnings-to-price, cash-flow-to-price, sales-to-price, or book-to-market value, all provide information as to returns while all giving different answers over different time periods. In addition, as the authors note, their research shows that combining multiple measures of value, instead of relying on just one can lead to stronger results for the factor. For momentum, the past 12-month return, skipping the most recent month's return (to avoid microstructure and liquidity biases), is the most frequently used measure. However, the alternatives used provide similar results.

Myth #10: There is no theory behind momentum

"The behavioral models typically explain momentum as either an underreaction or delayed overreaction phenomenon (it is of course possible that both occur, making it harder to empirically sort things out). In the case of underreaction, the idea is that information travels slowly into prices for a variety of reasons (e.g., investors being too conservative, being inattentive, facing liquidity issues, or displaying the disposition effect - the tendency to sell winners too quickly and hold onto losers too long). In the case of overreaction, investors may chase returns, providing a feedback mechanism that drives prices even higher."

In addition, in bear markets forced selling by margin calls can lead to momentum, as can short squeezes in bull markets. There are even some risk-based explanations. Whatever the case, the risk explanations can persist, as can the behavioral ones.

Summary

The authors conclude that to believe that the momentum premium doesn't exist, hasn't been persistent or pervasive, it's too volatile, it's too small, or it's not capturable due to trading costs, requires either ignorance of the data or ignoring it.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Source: Myths About Momentum: Part II