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Ghosts in the Momentum Machine

Do other factors lurk in the strategy's strong long-term track record?

Shannon Zimmerman, 02/10/2011

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As an analyst, I'm a fundamentalist at heart, focusing primarily on fund managers whose success owes to bottom-up research and strict valuation work. In advance of a panel I'll moderate at this summer's Morningstar Investment Conference, though, I've been researching the scholarship surrounding a technical strategy: investing purely on the basis of upward price momentum.

It's a fascinating topic, particularly for those who favor fundamental money managers, a group that, on average, has generally lost to the relevant bogies.

Contrary to that track record, the data on price momentum seem to show remarkable long-haul success. Tom Hancock--co-head of GMO's global quantitative equity team--has crunched the numbers and found that, between 1927 and 2009, a simple strategy of investing in stocks with the highest trailing-12-month returns surpassed the broader market by 3 annualized percentage points.

And Yet .
A healthy dose of skepticism is in order. While momentum may look terrific under laboratory conditions, it can be devilishly difficult for actual investors to exploit. The strategy Hancock tested requires monthly rebalancing of a super-sized portfolio, one comprising fully the best-performing quartile of U.S. large-cap stocks.

That's an onerous task and an expensive one, given the level of portfolio churn. It's no surprise, then, that the universe of pure-play momentum funds is exceedingly small. Nor is it a head-scratcher that many funds using the tactic as an element within a broader strategy have struggled long-term--Brandywine BRWIX, American Century Ultra, TWCUX and Turner Midcap Growth Investor TMGFX prominent among them.

Transaction costs drag on returns, after all. And, as with any strategy, price momentum's effectiveness waxes and wanes. Though it notched a strong return to form in 2010, the previous decade was exceedingly tough on the tactic. Those scars still show.PAGEBREAK

Blinded by Science
Substantial challenges exist even in the lab. Famously, correlation isn't causation, but when back-testing for a particular signal, that often becomes a distinction without much of a difference: The range of answers any set of data provides is always circumscribed by the questions an analyst asks, making it all too easy to simply find what you're looking for.

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