Value and Momentum Strategies for Asset Allocation and Stock Investment

by: MyPlanIQ

In the previous article, we introduced the concept of diversifying investment strategy styles. In this article, we will discuss value and momentum strategy styles in some detail.

  • Value investment: this has been one of the major styles employed by many famed investors including Warren Buffett in stock and bond investment (Buffett's value investment in bonds, though less well known, is as impressive as his stock investment).

    1. Relative value investment in Asset Allocation: among major assets, their relative values are computed and then are ranked across those assets. The cheapest assets are invested and the most expensive assets are sold. The hardest issue here is how to come up with comparable values across disparate asset classes. In the strategy Global Tactical Asset Allocation Value Based, earning yields (i.e. Earning/Price) are used for equities while yields to maturity are used for the bonds. These yields are then adjusted with a constant assigned to each asset class. More detailed information could be found in Blitz and Van Vliet's paper Global Tactical Cross-Asset Allocation: Applying Value and Momentum Across Asset Classes on which the strategy is based. In another paper titled Value and Momentum Everywhere by Clifford Asness et. al from AQR Capital, a 5-year negative return (price five years ago divided by current price) is used as "values" for commodities as well as currencies.

    2. Equities (stocks) value investing: there are many well known techniques here. Price Earning ratio (P/E), Price Book ratio (P/B), Price (Free) Cash Flow ratio etc. have been used as value measures. Many books and articles have been written. One of the most well defined (i.e. quantitative) method called Magic Formula Investing proposed by Joel Greenblatt has been widely followed. This strategy utilizes return on capital and earning yield (earning before income and tax/enterprise value) as the key criteria to select stocks.

  • Momentum investment: as one of the most popular investment styles, this has been often scolded as herd mentality or price chaser. The most often made mistake while pursuing this style of investing is to impulsively chase the hot stocks or sectors based on random information. It is, however, shown in both academic studies and in practice that momentum investing, if practiced in a systematic and disciplined way, does achieve excessive return over times. The most often used momentum is price based. Momentum driven investing is sometimes called trend following.

    1. Cross asset momentum: since very often, the price movement in major asset classes exhibits mega trends (one plausible reason for this is: since the major assets such as stocks or bonds are very much related to economic cycles, thus, their relative price direction is much correlated to economic development, which tends to sustain for a period of time). The strategies such as Global Tactical Asset Allocation Momentum have shown superior risk adjusted returns in the past ten years which encompass two recessions.

    2. Stock price momentum: there are a plethora of techniques here. Most technical indicators are trying to pin point the price trend. The following are three effective ways for momentum stock investing.

      • Moving average based for major stock indexes: the simple moving average (SMA) applied to various stock indexes such as S&P 500 (NYSEARCA:SPY), Russell 2000 (NYSEARCA:IWM) or Nasdaq 100 (QQQQ) have been reasonably effective in terms of risk adjusted returns. Interested readers could find the strategy Moving Average for Equity and study its model portfolios (or create your own portfolios). To further reduce the whipsaw noise, techniques such as MACD or moving average cross-over are often used. For example, from 3/31/1989 to 7/31/2009, the simple moving average 50 days and 200 days cross over (so-called golden cross) for S&P 500 produced 10.8% annualized return, compared with 9.6% annualized return using simple moving average 200 days strategy in the same period.

      • Sector (industry) rotation and/or country rotation: the momentum strategy has been well recognized and recommended by various firms. For example, S&P has long maintained an industry rotation strategies. One of the oldest sector rotation strategies is the Fidelity sector funds based, as Fidelity has offered very diverse sector funds for quite a long time. Our Sector Rotation Fidelity Selected Funds strategy had a miserable 2008 (the monthly adjusted portfolio was a 34.2% loss in 2008) but since then has recovered (up to 7/31/2009, its 5-year annualized return is 11.8%). Notice that this strategy has a higher standard deviation (26.9%) compared with 24% of S&P 500's index (such as SPY). An ETF portfolio could be constructed correspondingly. Such a portfolio, unfortunately, has a much worse performance. It does illustrate that the actively managed Fidelity Select funds delivers excessive (alpha) value over passively managed ETFs and that care should be taken when using industry ETFs.

        When it comes to international stock investment, the momentum strategy again could be used to rotate the country ETFs based on their price momentum.

      • Individual stock investing: with higher volatility (and higher maximum draw down), momentum strategy could be applied to individual stocks. We maintain a portfolio which uses a momentum strategy for Nasdaq 100 stocks.

Value and momentum investing styles are two distinct styles which could complement with each other. In fact, in their paper, Blitz and Van Vliet suggested a portfolio which combines both styles.

We will have more followup articles to discuss other investment strategy styles.

Disclosure: No positions