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Profiting From the Madness of Crowds

The case for a low-cost momentum fund.

Samuel Lee, 10/11/2013

This article was published in the May 2013 issue of Morningstar ETFInvestor. Download a complimentary copy of Morningstar ETFInvestor here.

Momentum is the tendency for performance to persist. Barring perhaps Treasury bonds and Japanese stocks, momentum has been found in nearly every market and asset class studied. Its prevalence is the most convincing refutation of the efficient-markets hypothesis. In partnership with the Arizona State Retirement System, iShares earlier this year launched the iShares MSCI USA Momentum Factor MTUM, another sign that momentum strategies are becoming more common and commodified.

The fund is promising. It charges a slender 0.15% expense ratio. Its secondary market liquidity is decent, no doubt helped by ASRS' $100 million seed contribution to the fund. Most important, its exchange-traded fund wrapper and its sensible index construction methodology put to rest the biggest objection to momentum strategies: They cost too much in taxes, transaction costs, and management fees. MTUM's ETF structure mitigates some of the tax bite. And by dealing in today's highly liquid large- and mid-cap stocks, its frictional costs won't likely amount to much.

Why It Works
There are lots of stories out there that seek to explain why momentum exists, but the most convincing appeal to behavioral biases. The brain is a wonderful machine,  but it uses a lot of shortcuts or heuristics. In markets, these shortcuts can lead us to biased decisions. For one, we're slow to adjust to new information, "anchoring" our adjustments to old values. And we prefer to sell winners to lock in gains and hold on to losers with the hope of eventually breaking even, a bias called the "disposition effect." The combination of the two prevents stock prices from quickly adjusting to new information, leading to performance persistence.

More powerfully, when we observe price trends, we extrapolate them into the future, and when we see others riding the wave, we're tempted to join in. The bandwagon effect can send prices to extremes. Obviously, markets don't stay crazy forever. At some point, the fundamentals kick in, and momentum-driven movements suddenly reverse.

So, if you sell to lock in gains, don't want to sell losers because you're waiting to break even, get caught up in crowd psychology, or allow irrelevant information to affect your estimates of an asset's fair value--congratulations, you help make momentum possible!

There's no shame in it. Momentum doesn't originate from mania but begins with skepticism. Consider Apple AAPL. As Apple kept posting blockbuster results, sober analysts consistently underreacted to the evidence that Apple's growth trajectory was steeper than they expected. Apple always looked expensive--until it didn't. By 2012, after years of being wrong, many skeptics capitulated. Some became true believers. It's around this time that the slowpokes began showing up droves to throw fistfuls of cash at Apple stock, and the bandwagon effect took hold. Then, as manias are wont to do, it imploded.

When there is stupidity, there's a profit opportunity. I admit there's something unsavory about the way momentum strategies go about it. By purposefully investing with the crowd, the momentum investor often helps push prices away from fair value and profits by selling to the greater fool. The strategy is a favorite of stock brokers because they love the commission income from churning their clients’ accounts. Despite my misgivings, the evidence for the strategy's efficacy is so overwhelming it makes sense to apply it to one's portfolio provided one can do so cheaply. MTUM offers such an avenue.

Samuel Lee is an ETF Analyst with Morningstar.
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