Over time we’ve learned much from financial science and the forces or factors that help to explain where expected returns come from. The momentum factor identifies the tendency for positively/negatively performing assets to continue their positive/negative trajectory for a short amount of time into the future. Essentially the “winners” tend to stay winners and the “losers” tend to stay losers for a period of time. So what does the research suggest and how can investors benefit?
First a bit of background: The momentum effect, first written about in the early 1990’s, leaves efficient market hypothesis (EMH) proponents such as myself with a realism that’s hard to rectify. For EMH advocates price is king. In laymen’s terms: The best judge of any particular assets inherent worth is its current price, thanks to the millions of market participants (buyers and sellers) actively voting with their dollars. Momentum on the other hand contradicts this notion, at least over the short term.
Why does it exist?
The majority of factors that we target in building portfolios commonly have a risk based explanation for their performance, i.e. stocks outperforming bonds, small companies outperforming large companies or value outperforming growth over time. Attempting to explain the momentum factor’s performance through the conventional risk based lens is difficult.
Like these other factors, momentum has been persistent across time, asset classes and geography. However, its performance is best explained from a behavioral perspective. Other theories exist as to why winners stay winners and losers stay losers for a period of time, but the idea that investors tend to either over react or under react to news is a leading hypothesis. This suggests that markets aren’t perfectly efficient, a point to which I would begrudgingly agree. Perfectly being the key word. While over long periods of time, markets usually get it right, in short spurts security prices seem to have a bit of “noise” built into them.
The investment application of momentum
When looking at the addition of any factor to a portfolio, investors should always start out as cynics, requiring large amounts of supporting evidence. First, academia must backup its inclusion with rigorous empirical research. Second, it can’t just look good on paper. Practical application dictates that investors must be able to capture the performance after any additional costs associated with targeting it. For a long time, this was a key issue with incorporating the momentum factor. Due to the frequent changes to the winners and loser’s categories, does the increased trading cost associated with buying and selling surpass the benefit? Furthermore, does its inclusion dilute the all-important diversification of the portfolio?
Not only must an investment vehicle exist, but the right vehicle has to be selected from a universe of thousands. Adding further complexity, is how it interacts and/or complements the rest of the portfolio. We believe that momentum is most effectively targeted through a low cost, quantitative, rules based methodology. This approach helps to lower cost and improve overall portfolio diversification. Investors commonly associate diversification with the benefits of different sizes and styles of asset classes which don’t always move in the same direction under different market conditions. Well, the same logic can in certain instances be applied to diversifying exposure to factors. Such is the case when momentum is properly paired with value due to their negative correlations with each other.
In sum, momentum has the ability to offer long term performance and diversification benefits when it is properly implemented. As a firm that specializes in factor based investing we remain dedicated to research and the practical application of it. This translates into ever evolving, globally diversified portfolios which target areas that drive expected return.
By Tim Baker, CFP®
Advice and investment design should rely on long term, proven evidence. This column is dedicated to helping investors across the country, from all walks of life to understand the benefits of disciplined investing and the importance of planning.