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The Wisdom of Herds

Following momentum's 2010 comeback, is there a role for the tactic in your portfolio?

Shannon Zimmerman, 01/14/2011

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Despite ample evidence that momentum-based strategies can work, fundamentally focused investors can sometimes be dismissive of them. Facts can be stubborn, though. After taking a drubbing during the 2008 debacle and, in relative terms, 2009 as well, the strategy returned to historical form in 2010, with each of AQR's momentum-based indexes--U.S. Large Cap, U.S. Small Cap, and International--besting their relevant, market-cap-weighted counterparts by significant margins.

Launched in July 2009, moreover, the shop's AQR Momentum AMOMX delivered a strong first full calendar year, too, surpassing the large-growth category norm by more than 3 percentage points en route to a gain of 18.6%.

Rewards ...
Momentum gets a bad rap in part because it seems too easy. Rather than poring over a company's financials, assessing its executives, and constructing elaborate valuation models, momentum investors ask a single question--what's working now?--and invest accordingly. There are variations on the approach--some momentum strategies incorporate earnings data and relative strength among their criteria--but one remarkably simple tack has enjoyed remarkable success.

In a paper published last year, Tom Hancock--co-head of GMO's global quantitative equity team--found that, between 1927 and 2009, a strategy of investing in the top quartile of stocks based on trailing 12-month returns outperformed the market by an annualized 3%. One common variation--excluding returns generated in the 12th month of the time series--outperformed by an annualized 4%.

... and Risks
Momentum-based returns come with plenty of potential risk, though. Turnover (and therefore transactions costs) can be high, taking a bite out of those outsize returns. The tactic can tank during downturns, too, with the market's highest fliers having the farthest to fall when sell-offs ensue. Nor is there a guarantee that momentum purists will enjoy full participation in a given rally: Shellacked during the market's 2008 debacle, the strategy badly underperformed amid 2009's dramatic rally, too.

The take-away from 2010's reversal of fortune, however, isn't that momentum is "back." Rather, it's that, like all winning investment approaches, this one requires patience. It's best used in tandem with other strategies, too. Savvy asset allocators, for instance, might consider carving out just a sliver of their pie charts for momentum. Doing so can add not just potential for market-beating returns but also a layer of strategic diversification as well.PAGEBREAK

That's particularly true, I'd argue, for folks whose lineups may tilt heavily toward valuation-sensitive bottom-up stock-pickers, dyed-in-the-wool "fundamentalists" who rely on discounted cash-flow analysis for their work. We don't often think of it in risk-centric terms, but exposure to that strategy constitutes a risk factor, too: Like momentum, it's an approach destined to fare better in some markets than others.

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