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The Trouble With Momentum – And What To Do About It

Summary Growth stocks have outperformed value stocks in recent years, which is shining a spotlight on momentum. Unlike other investment factors, the momentum premium has been persistent since it was identified by financial academics in the 1990s. We believe that combining momentum with value and other factors within a multi-factor framework is a compelling way to address the challenge of tapping momentum profitably in a growth portfolio. It’s no secret that growth stocks have outperformed value stocks in recent years. For example, in the two years from September 1, 2013 to August 31, 2015, large cap growth stocks (as measured by the Russell 1000 Growth Index) returned 14.7% annualized vs. 9.6% annualized for value stocks (Russell 1000 Value Index). This pattern of outperformance has shone a spotlight on momentum , an investment factor that works particularly well in growth-stock investing. But making money by identifying growth stocks with momentum characteristics isn’t as easy as it sounds. In this column, I will explain why and briefly describe how Gerstein Fisher addresses some of the problems inherent in tilting a growth stock portfolio to momentum. Momentum: a Persistent Investment Factor First, let’s define what we mean by momentum. Momentum is the tendency for winning stocks (that is, stocks that have outperformed the market over the past three to 12 months) to keep winning and losing stocks to keep losing. First identified in papers co-authored in the early 1990s by Sheridan Titman, one of our Academic Partners, the momentum factor would seem to refute the weak form of the Efficient Market Hypothesis, which asserts that stock prices reflect all available information and that past price movements should be unrelated to future average returns. Momentum suggests that prior movements in price are in fact related to expected stock returns – that security prices essentially have memory, which students of statistics will recognize as serial correlation. Since those landmark studies in the 1990s, a number of other academic papers have established that a momentum strategy works not only in equity markets around the world (with the notable exception of Japan’s) but also in several other asset classes, including currencies and commodities. At Gerstein Fisher, we find that a momentum tilt works at least as well in our multi-factor real estate investment trust (aka REIT) portfolio as in our US and international growth equity strategies. Exhibit 1 shows the compound annualized returns from 1927 to 2014 for 10 portfolios formed on momentum (defined here as the one-year return skipping the most recent month). Investing in the highest past one-year return (i.e., highest-momentum) stocks generated a 16.9% annualized return, while the lowest decile of momentum lost 1.5% per year. Note the steady improvement in performance as momentum increases. (click to enlarge) Moreover, unlike some other investment factors identified by financial academics, momentum has remained remarkably robust and persistent. For instance, since the size premium for small cap stocks was identified in the early 1980s, it has shrunk dramatically (see my recent column for more on this phenomenon: ” Is the Small Cap Stock Premium Disappearing? “); similarly, the value premium has also sharply declined since Fama and French published their pioneering paper on it in 1992. Quite possibly, once seminal research is available in the public domain, quantitative investors target and thereby reduce the available premiums, although they still exist. But momentum seems to be different: our research shows that the strategy has remained profitable, generating a momentum premium of five to seven percentage points* even years after Prof. Titman’s groundbreaking papers in the 1990s. The Challenge for Momentum So if all of this academic and empirical evidence for momentum is present, then what’s the problem? For one thing, momentum stocks are also subject to short-term reversals, the tendency for stocks that have risen relative to the rest of the market in the last month to underperform those that have fallen relative to the rest of the market (for more on this topic, see our recently posted paper: ” Do past returns predict future returns? Evidence from Momentum and Short – Term Reversals “). In addition, the discipline and emotion-free decisions required to hold high-momentum winners and cut low-momentum losers every month are behaviorally difficult for many individual investors to make. Most importantly, there is a very large issue with turnover and transaction costs (and tax liabilities, if held in a taxable account) with a momentum growth stock portfolio. In short, without rules for controlling portfolio turnover, transaction costs will quickly devour a premium from a tilt to momentum (a monthly rebalanced, long-only momentum strategy may have a turnover of about 300%, implying a holding period of around four months). We believe that an effective approach to addressing the problem of excess turnover is by combining momentum, a so-called fast-moving factor, with value (which we may define, for instance, as a tilt to higher book-to-market stocks than the Russell 3000 Growth Index), a slow-moving factor. Combining these two negatively correlated factors in one portfolio provides factor diversification, which is a good thing since there are pronounced and different cycles to different factors. But we also find that by combining the signals of value and momentum, we can slow down portfolio trading dramatically and improve risk-adjusted performance, both relative to the index and compared to the sum of standalone value and momentum strategies-a typical advantage of a multi-factor strategy in one portfolio. We will soon publish our research on the optimum way to combine momentum and value in an academic journal. In the meantime, I invite you to read our working paper: ” Combining Value and Momentum “. Conclusion Growth stocks – and momentum – have been the source of strong performance in the stock market. The momentum premium is palpable but difficult to tap profitably in a growth portfolio. We believe that combining momentum with value and other factors within a multi-factor framework is a compelling way to address this challenge. *The momentum premium is defined as the returns of the highest 30% of large cap US stocks rated by momentum less the return of the lowest 30% of stocks rated by momentum. Data on momentum decile portfolios are taken from Ken French’s website. Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. (More…) 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.

Cost-Efficient Exposure To Momentum

By Alex Bryan In many cases, extrapolating past performance into the future is a bad idea. In fact, securities that have outperformed for several years tend to become more expensive and priced to offer lower returns going forward. But in the short run, recent performance trends tend to persist. Winners over the past six to 12 months tend to continue to outperform for the next several months, while those that have underperformed often continue to lag. This phenomenon is known as momentum. It has been observed in nearly every market studied and across different asset classes over long periods. Investors can get efficient exposure to stocks with positive momentum through iShares MSCI USA Momentum Factor (NYSEARCA: MTUM ) for a low 0.15% expense ratio. This fund tracks an MSCI index that targets large- and mid-cap stocks with strong risk-adjusted price momentum, which differentiates it from traditional momentum strategies studied in the academic literature. This focus on risk-adjusted performance may help moderate the fund’s risk profile and reduce turnover. Volatility in a stock influences price movements, but this component of returns may not last. Risk-adjusted momentum gives a better signal of directional price movements, which may be more likely to persist. MSCI built the fund’s index with capacity in mind, at the expense of style purity. It usually only reconstitutes twice a year and applies a wide buffer to reduce turnover. On paper, momentum strategies appear to work better with reconstitution every month, as momentum is strongest over shorter windows. But in practice, monthly reconstitution can create high turnover and transaction costs. The index’s more tempered approach may improve its cost-efficiency, though it can still experience high turnover. In fiscal 2014, its turnover was as high as 123%. However, it has not yet distributed a capital gain, thanks to the exchange-traded fund structure, which allows managers to transfer holdings out of the portfolio through a nontaxable in-kind transaction with its authorized participants. Momentum is less likely to persist when volatility spikes. In order to address this potential problem, the fund’s benchmark applies conditional rebalancing in between the schedule reconstitution dates when market volatility significantly increases. When this rebalancing is triggered, the index focuses on more recent momentum to construct the portfolio. Investment Thesis In theory, investors should arbitrage any predictable price pattern away. Yet simple momentum strategies have historically worked (on paper) in nearly every market studied. Behavioral finance offers the best explanation for the momentum effect. Those in this camp assert that investors tend to anchor their beliefs and are slow to update their views in response to new information. For instance, event studies have demonstrated that stocks that beat earnings expectations have historically tended to offer excess returns for many weeks after the announcement. Similarly, stocks that miss expectations have tended to continue to underperform. Investors may also be reluctant to sell losers in the hope of breaking even and quick to sell winners in order to lock in gains. This irrational behavior may prevent stocks from quickly adjusting to new information. Once a trend is established, investors may pile on a trade or over-extrapolate recent results, pushing prices away from their fair values, which may contribute to the long-term reversals underlying the value effect (the tendency for stocks trading at low valuations to outperform). While momentum strategies have a good long-term record, they may struggle during periods of high volatility or market reversals. As a result, the fund can underperform when it is most painful. For instance, its benchmark lagged the MSCI USA Index by 3.8% during 2008. Heading into a bear market, momentum strategies tend to overweight riskier stocks, which may underperform during a correction. After a market downturn they tend to load up on defensive stocks, and they may miss out on some of the upside during a sharp recovery. There is also a risk that momentum may become less profitable as more investors attempt to take advantage of it. That said, the momentum effect hasn’t gone away even though it was first published in academic literature in 1993. Like any strategy, momentum can underperform for years. This risk may limit arbitrage and allow momentum to persist. MTUM’s moderate style tilt takes some juice out of the strategy. However, it still captures the essence of the style and at a lower cost than if it pursued a more aggressive rebalancing approach. It has a good chance of beating the market if momentum continues to pay off. But even if momentum doesn’t pan out, the fund’s low expense ratio doesn’t hurt performance much. This is a compelling holding on its own, but it can also offer good diversification benefits to value-oriented investors. That’s because momentum tends to work well when value doesn’t, and vice versa. Therefore, putting them together may reduce the risk of significantly underperforming, as the chart below illustrates. It shows the aggregate wealth accumulated in the MSCI USA Momentum Index, the Russell 1000 Value Index, and a portfolio split evenly between the two, divided by the wealth accumulated in the broad MSCI USA Index. When the line is sloping up, the strategy is beating the market, when it is sloping down, the strategy it is underperforming. Keep in mind that the MSCI USA Momentum Index’s live performance record only started in 2013. Sources: Morningstar Direct, Analyst Calculations. Portfolio Construction MTUM tracks the MSCI USA Momentum Index, which draws stocks from the market-cap-weighted MSCI USA Index, which includes large- and mid-cap stocks. In May and November, MSCI calculates the ratio of each stock’s price returns of the past 13 and seven months (excluding the most recent month to take into account the tendency for performance to reverse during that horizon) to its volatility during the past three years. There isn’t a great theoretical reason to use price returns rather than total returns, but it shouldn’t make a big difference. The index averages these two scores and selects the highest-scoring stocks until it reaches a fixed target number of stocks (currently 122). In order to reduce turnover, new constituents must rank in the top half of the index’s target number of securities to get priority over stocks that were previously in the index. Stocks already in the index only have to rank within 1.5 times the target number of securities to remain in the index. Holdings are weighted according to both the strength of their risk-adjusted momentum and their market capitalization, subject to a 5% cap. In addition to the scheduled semiannual reconstitution, MSCI may rebalance the index when the month-over-month change in the trailing three-month volatility of the market is larger than the 95th percentile of such monthly changes historically. When this occurs, the index only uses each stock’s seven-month risk-adjusted momentum score. Alternatives AQR offers some of the purest momentum funds on the market. However, these funds are only available in a mutual fund format, which can make them less tax-efficient. AQR Large Cap Momentum (MUTF: AMOMX ) (0.49%) ranks the largest 1,000 U.S. stocks by total return over the prior 12 months, excluding the most recent month, and targets the third with the strongest momentum. It weights its holdings according to both the strength of their momentum and market capitalization and rebalances monthly with an adjustment to reduce turnover. While AQR Large Cap Momentum’s $5 million minimum investment may seem a little steep, there is no minimum investment for investors who gain access to the fund through a financial advisor. AQR International Momentum (MUTF: AIMOX ) (0.65% expense ratio) and AQR Small Cap Momentum (MUTF: ASMOX ) (0.65% expense ratio) might also be worth considering. PowerShares DWA Momentum ETF (NYSEARCA: PDP ) is another option, but it is difficult to justify its 0.65% expense ratio. It targets stocks with the best relative strength and rebalances its portfolio quarterly. Historically, PDP has been less sensitive to the standard momentum factor documented in the academic literature than MTUM. Disclosure: Morningstar, Inc. licenses its indexes to institutions for a variety of reasons, including the creation of investment products and the benchmarking of existing products. When licensing indexes for the creation or benchmarking of investment products, Morningstar receives fees that are mainly based on fund assets under management. As of Sept. 30, 2012, AlphaPro Management, BlackRock Asset Management, First Asset, First Trust, Invesco, Merrill Lynch, Northern Trust, Nuveen, and Van Eck license one or more Morningstar indexes for this purpose. These investment products are not sponsored, issued, marketed, or sold by Morningstar. Morningstar does not make any representation regarding the advisability of investing in any investment product based on or benchmarked against a Morningstar index.