A few years ago I attended an iShares gathering right when 'strategic beta' (no, I don't call it 'smart beta') emerged as an increasing focal point for ETF product innovation. The speaker walked through the series of single factor ETFs based on MSCI Factor Indices and why several institutions, such as the Arizona State Retirement, were adopting strategic beta strategies. When the topic came to momentum, the speaker immediately confessed a certain level of confusion on why the momentum anomaly exists when, from an efficient market hypothesis ("EMH") standpoint, prices should follow a random walk rather than a trend line (or just because the price of an asset was higher yesterday doesn't mean it should be higher tomorrow).
Momentum has become a recent hot topic because it was one of few strategies to have performed well in a difficult 2015 market environment (Exhibit 1).
Exhibit 1 - Momentum King of 2015
Yet, Momentum is struggling this year as the snap-back rally off the February lows has left last year's winners lagging last year's losers (Exhibit 2).
Exhibit 2 - Revenge of the Contrarian
On the surface, momentum is anti-intuitive for many investors, whether those who subscribe to EMH, those who are contrarian, or those who just like rooting for the underdog. At various points in my career, I subscribed to all three viewpoints and had looked with disdain on investors who pushed growth momentum strategies. But at the core of my disdain was a lack of understanding and appreciation for why the momentum anomaly persists, whether in stocks, commodities, or currencies.
What is Momentum?
Despite being anchored to a contrarian view, there was this nagging observation that 52-week highs more often made new highs while 52-week lows made new lows. In a majority of cases, it doesn't pay to be a contrarian and you're better off betting on a basket of winners rather than losers. So what is momentum exactly?
Technically speaking, momentum represents an accelerated (2nd derivative) move off a positive or negative trend (1st derivative), but many investors associate momentum with both. Simple momentum investing involves
- calculating an asset class' return over a short-term (3- or 6-months) or intermediate-term (12- or 18-months) time frame and then
- taking the difference between the outperforming versus underperforming securities or sub-asset classes.
Many technicians or chartists favor positively trending asset prices and monitor moving averages such as the 90-day or 200-day moving average. The key is to look for 'breaks' in trend or momentum such as the breach of 1) moving average levels, 2) the cross-over of the short-term over the long-term moving average (so-called death cross), or 3) the breach of other support/resistance levels (i.e. head-and-shoulders). I had been a skeptic of technical analysis, but an ex-colleague reminded me that it doesn't matter whether I believe in technical analysis since enough market participants do subscribe to technical analysis to the extent that this worldview of investing can affect market pricing. This is most evident in currency markets due to the presence of dynamic hedgers who constantly adjust positions based on price trends.
From a factor or strategic beta standpoint, momentum can be defined as buying a basket of last year's winners and shorting last year's losers. Please refer to the Fama/French/Carhart study on momentum which includes an abbreviated literature review of academic work studying the momentum effect. The study observes positive risk-adjusted returns over most major regions, except Japan which has been driven more by intermediate price reversal (no surprise given that Japan has suffered from a two decade+ bear market). Even die-hard EMH-ers such as Eugene Fama entertain the possible presence of momentum as a sustainable and persistent anomaly but struggle to provide an explanation for why investors should be compensated for taking on momentum risk and ultimately dismiss momentum as uninvestable. Larry Swedroe at ETF.com provides a useful summary of the long-term premia associated with mainstream factors. Momentum generates the highest return but also the highest risk (uncertainty) among the four factor premia.
Ultimately, momentum represents success and failure, and we are, paradoxically, attracted to, but repulsed by, success and seek to avoid, but yet be sympathetic to, failure. We are attracted to success stories but success can breed arrogance and an air of superiority (think 1990s internet bubble, 2000s housing market) that we find ourselves rooting against this success. Likewise, we seek to avoid failures but become sympathetic to down-on-your-luck stories and root for a turnaround. Fans skewered Lebron James for sporting a New York Yankees cap rather than a Cleveland Indians cap, even though they represent storied franchises of success and failure, respectively.
Risk-Based or Behavioral?
So is the momentum anomaly rooted in a risk-premia or explained by behavioral phenomena? My answer is "Yes."
Is Momentum a risk premium that investors should be compensated for as they are with the other Fama/French factors (market, size, value)? Statistically, momentum is much more volatile than the other factors. When momentum fails, it can fail spectacularly as was the case in the August 2007 quant meltdown and the 2009 deep value market recovery. But there are plenty of other highly volatile factors that investors are not compensated for (many of them fall in the growth category). I've yet to see an academic-based reason for why momentum should be viewed as a risk premium, but I would like to proffer one.
Investing in today's winners actually poses uncertainties to the investors because success breeds competition and new innovations that can threaten today's successful business models (Schumpeter's Creative Destruction). It's hard to picture how today's winners could not sustain their success in the future, but one only has to point to last decade's dominant industry tech players (Cisco, Microsoft, Intel) giving up leadership to today's tech/social media darlings (Facebook, Alphabet). As is a common industry practice when disclosing performance, pass success does not guarantee future results, and this uncertainty of mean reversion and creative destruction is why momentum investors should be compensated for taking on this risk. A similar rationale can be made for quality factors using historic profitability. Highly profitable companies (based on metrics such as return on equity) can compensate investors for the risk that those profitability levels are 1) abnormal and 2) unsustainable over the long run due to the threat of competition. Some companies are able to sustain their profitability over longer periods of time (so-called Moat companies) but these situations are less episodic (more the exception than the rule), so investors need to be compensated for the risk that this profitability is eventually eroded.
However, beyond the Fama/French worldview of risk premia rationales, most investors would subscribe to behavioral reasons for explaining the momentum effect. I confess that behavioral explanations are more intuitively appealing than risk-based explanations. Mark Anson (CAIA Level II: Advanced Core Topics in Alternative Investments) provides a good summary of academic literature explaining behavioral influences on asset pricing. If capital markets are rational, prices ultimately track intrinsic values, but some behaviors (anchoring, disposition effect) can lead investors to underreact to new information causing prices to lag while other behaviors (herding, confirmation bias) cause investors to overreact to new information causing prices to overshoot intrinsic values. The key for technical and momentum-driven investors is to distinguish between the two since the latter can be subject to violent mean reversion.
A Fundamental Explanation for Momentum?
Traditional fundamentally-driven investors may scoff at technical analysis but when would they ever openly admit that they hold a portfolio of failures? Even value investors will emphasize the presence of a 'catalyst' as a necessary condition for buying undervalued companies. Whether explicit or not, most professional investors incorporate some form of momentum as a heuristic that goes into their decision-making process just as most professional investors incorporate value (again, who would ever admit they own a portfolio of overvalued securities?).
Momentum works because it is a broader reflection of sentiment within the business world. Momentum compounds over time - success breeds success and failure breeds failure. Successful firms, as measured by profitability, innovation, capital management, engender this discipline through the corporate culture that helps sustain the enterprise to create future success. Likewise, failure compounds because it ultimately affects company morale whereby corporate culture becomes sclerotic leading to a downward cycle of value destruction. When a company is consistently losing money, losing market share to competitors, not earning their cost of capital, this failure is very difficult to turn around (it's one reason why investors are compensated for taking on value risk). This is a reason why many value managers look for management changes as the so-called catalyst for making investments.
Investing in Momentum
Given the popularity in momentum style of investing, there has been a proliferation of single and multi-factor ETFs designed to capture this phenomenon. For momentum strategies, I tend to favor cost-effective solutions with easy-to-understand decision rules for portfolio construction. In particular, I favor momentum strategies that apply a risk adjustment (market beta adjustment) to the price series, since such risk adjustments have been known to dampen volatility associated with the factor. Two current momentum ETFs I favor right now are the iShares US Momentum Factor (NYSEARCA:MTUM) and the momentum strategies captured in the Goldman Sachs ActiveBeta ETF series, such as the Goldman Sachs ActiveBeta International Equity (NYSEARCA:GSIE). The bottom line for any momentum investor is not to bet solely on this strategy to the exclusion of others but to incorporate as part of a diversified portfolio.
Disclosure: I am/we are long MTUM, GSIE.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: At the time of writing, 3D Asset Management held positions in both MTUM and GSIE. The above is the opinion of the author and should not be relied upon as investment advice or a forecast of the future. It is not a recommendation, offer or solicitation to buy or sell any securities or implement any investment strategy. It is for informational purposes only. The above statistics, data, anecdotes and opinions of others are assumed to be true and accurate; however, 3D Asset Management does not warrant the accuracy of any of these. There is also no assurance that any of the above are all inclusive or complete. Past performance is no guarantee of future results. None of the services offered by 3D Asset Management are insured by the FDIC, and the reader is reminded that all investments contain risk. The opinions offered above are as of April 22, 2016, and are subject to change as influencing factors change. More detail regarding 3D Asset Management, its products, services, personnel, fees and investment methodologies are available in the firm’s Form ADV Part 2, which is available upon request by calling (860) 291-1998, option 2, or emailing firstname.lastname@example.org or visiting 3D’s website atwww.3dadvisor.com.