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Big Mo

There’s more, and less, than meets the eye in momentum’s longterm track record.

Shannon Zimmerman, 10/09/2012

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 AMOMX, a pure, institutional play on the strategy, also delivered a strong year. That large-growth fund surpassed its average rival by more than 3 percentage points in 2010, en route to a total return that year of 18.6%. Launched in July 2009, AQR Momentum has earned a Morningstar Analyst Rating of Bronze, and its annualized gain of 14.4% in the trailing three years through August places in the peer group’s top quartile. It ranks in the top quartile for the year-to-date period, a stretch in which the fund has surpassed not only the category norm but also its Russell 1000 and Russell 1000 Growth Index benchmarks.

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.

Those exposures don’t reflect management’s views on the relative attractiveness of the market’s sectors, however. AQR Momentum’s portfolio comprises the top third of domestic large- and mid-cap companies as ranked according to their share-price performance during the preceding 12 months. That’s it. If that approach leads to lopsided sector weightings, so be it. The managers won’t bring it back in line. With tech and consumer discretionary stocks pacing the market over the past year, then, it’s not surprising to find those sectors well-represented in the fund’s current portfolio.

While momentum’s simplicity is particularly alluring in light of the tactic’s long-term results, it follows, of course, that that strength is of a piece with a central weakness: Investors can quickly find themselves in the wrong place at the wrong time when what was working suddenly stops. Along with that vulnerability to market inflection points, the degree to which the strategy complements other approaches is also problematic, as a history lesson from quant manager Bridgeway Capital Management shows.

Play Nice?
While the long-term profile of this Houston based asset manager remains solid, Bridgeway has had a tough time in recent years. That appears to owe at least in part to the more fundamental models it employs alongside the others it uses to construct its funds’ portfolios. Those models steered the shop away from the riskier stocks that enjoyed the most dramatic price appreciation during the rally that began in March 2009.

Bridgeway keeps the details of its models under wraps, but it’s known that momentum is among the factors they model. At a glance, that makes the firm’s underperformance in 2010—generally a good one for momentum— surprising: Of the 11 Bridgeway funds that existed during the full year, only two placed in the top half of their respective categories. Yet while the AQR fund delivered top-quartile gains in 2010, Bridgeway’s large-growth offering, Bridgeway Large-Cap Growth BRLGX, placed in the category’s bottom third.

There are several key differences between Bridgeway and AQR, though. Momentum is just one of several factors in the shop’s models, for example, and price momentum (the variant of the tactic that AQR employs) features in just one of its funds, Bridgeway Small-Cap Momentum BRSMX. The firm places a premium on risk management, too, using models that target, among other things, downside risk, valuation attractiveness, and fundamental health.

Amid the flight to risk that began in the first quarter of 2009, those attributes weren’t much in vogue. Lower-quality, speculative fare (which Bridgeway had scant exposure to) led the way instead. For an extended period of time, in fact, the shop’s returns suffered on a relative basis partly because its models successfully identified many companies that, subsequent to a Bridgeway fund purchasing them, went on to exceed Wall Street’s earnings forecast. In some cases, as Bridgeway noted in a shareholder report, the bigger a company’s upside earnings surprise, the worse its stock performed.

Momentum and Fundamentals
If Bridgeway’s experience in 2010 provides a cautionary tale about the way momentum can sometimes interact with more fundamentally focused strategies, other examples indicate that, depending on the market environment it’s deployed within and on investors’ time horizons as well, the tactic can complement such approaches. AQR’s research, for instance, indicates that momentum is negatively correlated with value and, because it has historically generated greater alpha, it pairs better with a portfolio’s allocation to value than does growth.

Elsewhere, GMO’s Tom Hancock has argued that share-price momentum anticipates a company’s improving fundamentals. And irrespective of whether Bridgeway’s momentum and fundamental models worked at cross purposes during 2010, the overall result of the shop’s models was a firmwide tilt toward fundamental overachievers, albeit at a time when earnings success wasn’t well-rewarded relative to riskier fare.

Chase Growth CHASX—a large-growth fund whose bottom-up, quality-biased managers also use momentum—suffered a fate similar to Bridgeway’s in 2010. The fund boasts a remarkable long-term track record, though. Between 1998 and July 2012, it suffered just 62% of its average rival’s losses in declining markets en route to a total return more than twice the category norm. Similarly, Bridgeway’s oldest offerings— Aggressive Investors I BRAGX and Ultra-Small Company BRUSX, both of which launched in 1994—reside in the sixth and fifth percentiles of their respective categories for the trailing 15-year period through August.

For investors, the upshot of both the academic research around momentum and the practice of momentum investing as it has played out at firms like Bridgeway and Chase is that, in order to take advantage of the tactic’s historical tendency to outperform, patience and discipline are required. During some periods, the strategy will be out of favor. In others, gains that can be attributed to momentum may be eroded by losses associated with other strategies. For example, while momentum should do well when growth stocks lead the way, the tactic won’t likely outperform in value-paced markets. Moreover, while there is ample evidence to suggest that momentum can provide a powerful supplement to an investor’s well-diversified portfolio, there are also compelling reasons for skepticism.

Blinded by Science?
First, while momentum’s track record may look terrific under laboratory conditions, it can be a difficult strategy for investors to exploit. AQR Momentum’s initial investment minimum is $5 million. And do-it-yourselfers inclined to attempt the strategy GMO’s Hancock tested will need to rebalance, on a monthly basis, a supersized portfolio comprising the best-performing quartile of U.S. largecap stocks.

That’s an onerous task and a potentially expensive one, given the level of churn required. It comes as no surprise, then, that the universe of pure-play momentum funds is exceedingly small. Nor is it a head-scratcher that some funds making use of the tactic as an element within a broader strategy have struggled over the long term—Brandywine BRWIX, American Century Ultra TWCUX, and Turner Midcap Growth Investor TMGFX prominent among them. Transaction costs, after all, drag on returns.

Second, as with any strategy, momentum’s effectiveness waxes and wanes over time. In some market environments, it can cushion the effects of poor stock selection elsewhere in a portfolio, for example. In others, it will be swamped by those effects. In real time—as opposed to back-tested time—investors inevitably experience the jaggedness of trend lines that look straight over time series that are typically longer than most of them will be in the market.

Finally, substantial challenges exist even in the laboratory. Famously, correlation isn’t causation, but when back-testing for a particular signal, that sometimes becomes a distinction without a difference: The range of answers any set of data provides is always circumscribed by the questions a researcher asks. That makes it all too easy to find what we’re looking for and leave other possible explanations unexplored.

The risk of that kind of confirmation bias is nicely illustrated in the speech Vanguard founder Jack Bogle delivered as the keynote speaker at the 2002 Morningstar Investment Conference. Criticizing “the vastly oversimplified but typical way we look at long-term results,” Bogle zeroed in on the vaunted small-cap and value-stock premiums, showing that, although it may seem in the aggregate as if those two asset classes have persistently outperformed, that’s not what the data show. Relatively narrow portions of a time series spanning more than 70 years account for the bulk of those factors’ excess returns.

Might a similar dynamic be at work in the research surrounding momentum, with in-the-aggregate results leading to incomplete conclusions?

In a word, yes. Momentum is the most consistent and powerful of the factors, but it has become highly volatile over the past decade, even before the financial crisis. It badly lagged after the market’s March 2009 course correction, too. Also complicating the case for momentum is a dynamic that attends any effort to isolate the significance of a single variable in a vast sea of data: signal-to-noise risk. For example, in addition to the kind of time-series static underscored in Bogle’s speech, how much of momentum’s long-haul outperformance may owe to style?

Back to Basics
Morningstar Ibbotson has asked and answered the style question in a recent white paper that analyzes the influence of price momentum and liquidity on the returns of composite mutual fund portfolios. The data set is admittedly limited, but the conclusion is striking: Regardless of where in the Morningstar Style Box they reside, portfolios comprising funds that provide the greatest level of exposure to high-momentum stocks significantly outperform those with the lowest levels.

Widening the analytical lens to control for style represents a gain in terms of understanding the persistence of momentum, partly because it prompts related questions. For example, what percentage of high-momentum funds account for the bulk of outperformance in each style box square? What attributes do those funds share? Do the bigger outperformers cluster near the lower-left corner of each square of the style box, suggesting that market-cap and valuation factors may also account for at least some portion of the excess return?

More fundamentally, what is the average manager tenure of these funds versus category norms? And given the predictive power of expense ratios and star ratings, what is the average star rating of the high-momentum group’s biggest contributors? What is the average price tag?

Widening the lens to include these and other more-qualitative questions can further strengthen our understanding of momentum, helping to clarify and refine what the tactic has actually contributed to an investor’s returns and what portion of the gains ascribed to it may owe to other attributes—profitability, say, or in the case of mutual funds, managerial tenure. Those and other attributes almost certainly account for a greater-than-zero percentage of the outperformance that might otherwise seem a byproduct of momentum. How much greater is a question in need of greater study.

 

References
Asness, Cliff, Moskowitz, Tobias J., and Lasse H. Pedersen (2009), “Value and Momentum Everywhere.”

Carhart, Mark M. (1997), “On Persistence in Mutual Fund Performance,” Journal of Finance, vol. 52 no. 1, March 1997, pp. 57–82.

Dimson, Elroy, Marsh, Paul, and Mike Staunton (2008), Global Investment Returns Yearbook 2008.

Jegadeesh, Narasimhan, and Sheridan Titman (1993), “Returns to Buying Winners and Selling Losers: Implications for Stock Market Efficiency,” Journal of Finance, vol. 48, pp. 65–91.

Shannon Zimmerman is an associate director of fund analysis at Morningstar.
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