This is the sixth article in the series that aims to develop portfolio investment approach that 'beats the market.' The goal is to equip the readers both with 'the knowledge about the path' and 'the confidence to stay on the path.'
In the previous articles we have reviewed three theories of investment and how they can help in developing superior portfolios:
- In the first article, Efficient Market Hypothesis And Random Walk Theory: Buy 'David Swensen's Portfolio, the author recommended using the Swensen portfolio.
- In the second article, Modern Portfolio Theory: Introduce Allocation To 'Alternatives', we suggested ways of enhancing the Swensen portfolio through adding alternative assets to the portfolio.
- In the third article, Tilt Your Portfolio to Achieve Superior Returns, we discussed Noisy Market Hypothesis and reviewed historical performance of small cap and value stocks. We highlighted a list of ETFs that could be utilized to 'beat the market.'
- In the fourth article, Different Take On A Dividend Growth Investing, we reviewed how dividend growth investing, Dogs of Dow and Core 10 can be used to beat the market.
- In the fifth article, Will Low Volatility ETFs Save You During Market Turbulence?, we reviewed how low volatility stocks outperform during various market cycles.
Initial two articles serve as a practical guide to structuring the core portfolio. In the later articles, we started discussing strategies for the model satellite portfolio.
Historically, momentum investing showed impressive results in various capital markets over the world (e.g. US, EU, Japan) and various asset groups (e.g. stocks, bonds). White paper from AQR reviewing performance of annual premiums of various factors from 1927 to 2011 shows how impressive such momentum premium could be:
AQR whitepaper also indicates momentum factor has a negative correlation with other factors (-0.20 with Market, -0.24 with Value, and -0.25 with Size), indicating potential for significant diversification among factors. We will discuss this topic in detail in the future article dedicated to multifactor investing.
In other words, momentum investing has exhibited sizable excess return and negative correlation with other factors. Both of these points make it a good candidate for inclusion into our satellite portfolio.
Momentum investing: absolute and relative
Absolute momentum investing involves focusing on the performance of a specific asset (e.g. stock, ETF) to determine whether to buy or sell it. On the other hand, relative momentum investing involves comparing the performance of one asset class or stock to the performance of another to determine which one should be bought and which one should be sold or shorted. Past winners would be bought and past losers sold.
There are a few concerns that might jump at well-trained contrarian. Buying recent winners which tend to be over-valued by that point is not a good long-term strategy. One would expect that over-valued asset to perform poorly.
Interestingly, an investor can simultaneously utilize momentum investing in the medium term and remain contrarian in long term. Let me clarify, momentum investing typically involves looking back at the performance of asset during last 3 to 12 months while contrarian strategies, typically, are either focused on the very short term (days to weeks) or long term (over 3 years) mean reversion.
Why do I think that momentum investing will continue generating alpha?
In the previous article, we have shown that Capital Asset Pricing Model ("CAPM") is unable to explain outperformance of low beta stocks. The possibility of earning higher yield while being exposed to lower risk goes against fundamental tenants of Efficient Market Hypothesis ("EMH").
However, if you subscribe to the camp of advocates of the noisy market hypothesis ("NMH," please refer to the third article), you might as well accept that some factors (e.g. small size, value, and momentum) have provided superior returns.
On the other hand, EMH might have some explanation for momentum anomaly. Historical performance of momentum strategies indicates the existence of "momentum crashes." Momentum crashes are situations when strategy results in very large drawdowns (typically, momentum has a negative skew). EMH proponents, therefore, argue that momentum premium exists to compensate for such additional systematic risk.
Behavioral finance explanations focus on investor underreaction to important information and/or irrational behavior (e.g. loss aversion, conservatism bias, and lack of analyst coverage). Under-reaction argument suggests that important information takes time for market participants to fully digest and act on. There might be institutional limitations limiting high turnover of portfolio resulting in muted stock price reaction.
So here is the answer: I think that momentum anomaly will continue to yield excess return due to individual and institutional investor behavior. As long as we have a group of individual investors exhibiting irrational behavior and unable to "stay the course," users of momentum strategy would achieve very satisfactory results. They, however, would need to get comfortable with temporary momentum crashes and higher portfolio turnover.
Practical limitations or concerns
- Excessive portfolio turnover: the nature of momentum investing requires high turnover. It is possible to increase the frequency of rebalancing (e.g. monthly or quarterly) and, therefore, turnover during periods of high market volatility when it matters most.
- Large drawdowns and negative skew: this could partially be lowered by focusing on long-only investing, instead of long-short (i.e. long winners and short losers at the same time). However, the long-only strategy will still be subject to momentum crashes.
- Investor emotions: are you comfortable with "anti-contrarian" mindset? Are you confident that you will stick to the strategy during periods of high volatility?
Momentum investor tends to end up having high beta stocks during bull markets (i.e. in bull market higher beta stocks tend to outperform their low beta counterparts in 3-12 month windows). After bear markets, however, the beta profile of portfolio reverses as low beta stocks would have done better than higher beta stocks during the recent downturn.
This means that momentum investor would be "building up" beta as the market approaches peak and would be underexposed to 'market factor' coming out of the bear market. Both are examples of poor market timing. Momentum investor did not intentionally choose to engage in such poor form of market timing, it was driven by focusing solely on momentum factor and disregarding a market factor (i.e. beta) of the overall portfolio.
Therefore, it is important to monitor exposure of the portfolio to various factors. For instance, when reviewing value factor you might benefit from keeping quality factor exposure in mind and when reviewing momentum factor - keep the market factor of the portfolio in mind.
List of ETFs and Stocks
In his book "What Works on Wall Street" James O'Shaughnessy showed how combining momentum factors with value factors could significantly improve performance. One of his very popular strategies involved combining low P/E or low P/S ratios and 12-month relative momentum to identify a list of 25 or 50 stocks. We will not review his findings in detail here. It suffices to say that the results were very impressive.
I hesitate to recommend any ETF at this point, as I think you will find a discussion of "dual momentum" (i.e. combining absolute and relative momentum) and multi-factor investing that I plan to cover in the future articles useful before engaging in momentum investing.
However, to those of you who want to start taking exposure to momentum investing, I can highlight following two ETFs:
- The iShares MSCI USA Momentum Factor Index ETF (NYSEARCA:MTUM) (15bps of fee, 123 holdings, AUM $1.1 billion, turnover 106%) will give you an exposure to MSCI USA Momentum Index.
- The SPDR S&P 1500 Momentum Tilt ETF (NYSEARCA:MMTM) (12bps of fee, 1,366 holdings, AUM $15.9 million, turnover 70%) will give you an exposure to S&P 1500 Positive Momentum Tilt Index.
Both ETFs are classified as "Large Cap Growth" by Morningstar. In case you are wondering why I provide at least two ETFs in the articles and highlight which index they are tracking, you might find the answers by refresher reading on tax loss harvesting (for instance, refer to Investments 301 indicated in the bibliography).
Of course, there's an alternative to owning above mentioned ETFs. However, as I mentioned earlier, I would not recommend investing in specific stocks before you read next few articles that will cover dual momentum and multifactor investing.
Please don't forget to "follow me" so that you don't miss the future articles.
- Saidrasul Nasretdinov (2016) Investments 101: Step-by-Step Guide to Financial Independence for Millennials (60-Minute Investor)
- Saidrasul Nasretdinov (2016) Investments 201: Proven Ways of Beating The Market or Lessons from Investment Gurus
- Saidrasul Nasretdinov (2016) Investments 301: Tax Optimization or Beating IRS at Their Own Game
- Saidrasul Nasretdinov (2016) Investments 401: Emotional Control or Fighting Your Demons
- Saidrasul Nasretdinov (2016) Investments 501: Unconventional and Audacious Investment Approach for Millennials or Two-Million-Dollar Secret
- James O'Shaughnessy (1996) What Works on Wall Street, Fourth Edition: The Classic Guide to the Best-Performing Investment Strategies of All Time
- AQR publications
- Article #1: Efficient Market Hypothesis And Random Walk Theory: Buy 'David Swensen's Portfolio'
- Article #2: Modern Portfolio Theory: Introduce Allocation To 'Alternatives'
- Article #3: Tilt Your Portfolio to Achieve Superior Returns
- Article #4: Different Take on A Dividend Growth Investing
- Article #5: Will Low Volatility ETFs Save You During Market Turbulence?
Disclaimer: I'm not a tax advisor, please consult your tax advisor for any tax related matters.
ETFs discussed: MTUM and MMTM
Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in MTUM over 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.