There’s more, and less, than meets the eye in momentum’s longterm track record.
This article originally appeared in the October/November 2012 issue of MorningstarAdvisor magazine. To subscribe, please call 1-800-384-4000.
Despite ample evidence that momentumbased strategies work, fundamentally focused investors are often dismissive of them. Momentum gets a bad rap in part because it can be turnover intensive and, therefore, expensive to execute. For many fundamentalists, moreover, it simply seems too easy. Rather than poring over a company’s financials, assessing its executives, constructing elaborate valuation models, and forecasting earnings-growth rates for periods of up to a decade, momentum investors ask a single question—what’s working now?—and place their trades. There are variations on the approach. Some momentum strategies incorporate earnings data and relative strength among their criteria, for example. But one remarkably simple version of the tactic has enjoyed outsize success.
In “Momentum–A Contrarian Case for Following the Herd,” a white paper published in 2010, 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 price momentum variant—excluding returns generated in the 12th month of the time series and re-sorting the date to identify top performers—surpassed the market’s return by an annualized 4%.
Hancock’s results are consistent with earlier findings of excess returns that can be explained by momentum. The website of Kenneth French is a standard resource for academic momentum research; it provides downloadable spreadsheets documenting the factor’s outperformance between January 1927 and December 2011 using monthly and annual returns. Using daily returns, French also finds excess returns for the tactic between July 1963 and December 2011. Jegadeesh and Titman (1993) and Carhart (1997) also wrote groundbreaking papers on momentum.
Other researchers have examined the impact of momentum in non-U.S. markets, finding excess returns also persist abroad. Dimson, Marsh, and Staunton (2008), for example, have documented outperformance in the United Kingdom between 1900 and 2007. And in “Value and Momentum Everywhere,” Asness, Moskowitz, and Pedersen (2009) provide a useful overview of research into whether momentum’s outperformance transcends asset classes as well as geographic boundaries. It does, they find.
Risks & Rewards
Those are impressive results, yet trends that look linear and persistent over a lengthy time frame are typically far more jagged on closer inspection. So it is with momentum. The tactic is especially vulnerable to market inflection points, for example, and the strategy took drubbings not only during 2008’s dramatic sell-off but also in 2009’s dramatic recovery. Momentum returned to historical form in 2010’s comparatively calmer waters, though, with each of the momentum-based indexes created and tracked by quant researcher AQR besting the relevant benchmarks.
Unsurprisingly, AQR Momentum
Secrets of Success
Glancing at the AQR fund’s portfolio, investors might conclude that its recent success owes to bets on technology and consumer discretionary stocks, the two best-performing areas of the market so far in 2012. The fund is also light on the year’s worst performers, energy and utilities.