Momentum's Run and Stumbles

Zimmerman: At the market level as defined by the S&P, you're trying to have a beta of one relative to the S&P, is that…

Montgomery: Well this is a small-cap fund, so the Russell 2000 is our performance benchmark and how we think of the market in that area is.

Zimmerman: And the goal of the risk optimization is to have a neutral beta relative to the Russell 2000?

Montgomery: The beta actually can vary over time, but it's specifically in those infection points. So think of 2008, which wasn't too bad, but actually 2009 was much harder. It was one of the kind of blowups--simple price momentum lagged on the order of 10% in the small-cap space, and that's very unusual. That only happens every decade, maybe less. But the risk-adjustment part allowed us to have a slightly…

Zimmerman: Smoother ride?

Montgomery: ... I have to caveat that, of course, the performance of our fund is only a year old, so this is a model, and I need to disclose that with all of the normal things of the past doesn't equal the future. When you're talking about a back-tested return, there is an extra level of caveat there. We did just celebrate the one-year anniversary of the fund, and it's been an unusual period for momentum, both price momentum and other kinds of momentum.

Zimmerman: When you mentioned the infection point vulnerability, and a lot of funds that use momentum either as a sole model or as a part of an overall quantitative approach to management suffered quite a bit because momentum is vulnerable at infection points, which stands to reason--you're investing primarily based on the things that have done the best over the last 12 months, that was the most thoroughly documented form of price momentum. Then when things turn on the dime, as they did in late 2008, well then you're really stuck holding the wrong stocks for the most part.

Notwithstanding that infection point vulnerability, momentum has a remarkable track record of generating outperformance over decades, the CRSP Data goes back to 1929, I think, and over all the subsequent decades, it has generated alpha, and tomorrow we'll be on a panel with Tom Hancock of GMO who's done some number crunching around that. One flavor of momentum three annualized percentage points of outperformance relative to the broader market, a slightly tweaked version of price momentum, where you discount the last month's returns…

Montgomery: ...Short-term reversal effect.

Zimmerman: Exactly has done even better. It's such a simple strategy, so easily replicated, why does it persist as being an alpha-generating tactic?

Montgomery: Well so there is a whole body of research that's trying to answer that question, and honestly, I don't think we have a definitive answer to that. Value investing is kind of been around longer and more accepted, and it's a little easier to get your head around value, when something is very cheap relative to either prices or sales or book value. Something that creates value into the future, it kind of makes sense that reversion to mean prices would go up in the future.

So, price momentum is a little bit different. There are three theories about why that might be, and I think they are interesting. One is that there is a delay in absorbing news that comes out about a company. So, for example, an earnings report comes out and it's a good report; it's better than what Wall Street might expect. So you'd expect the price to have some adjustment with that and especially to the degree that that persists.

So, there is some theory that people discount that. It's like, things haven't been too good over the last few years. All of a sudden you have a good quarter and people are like, "I'm going to sit back and really see if this continues to happen." So, there is some theory that there could be some delay. Interesting of that one theory, that's the one that I think arguably could have declined over the last decade versus prior history.

Zimmerman: As it's become more well-known.

Montgomery: Well simply because we have more information, and computers are easily available to process it. I don't know whether that's true or not, but that's one theory.

Another theory that I really hold more sway in is that shareholders tend to sell their gains early, they lock in their gains and they let their -- interestingly they let their…

Zimmerman: Losers run.

Montgomery: ...Their losers run, which means there is some artificial pricing that would tend to have a momentum effect with it. So, that's a theory, and I've actually seen that first-hand at Bridgeway. In 1998 we had a very volatile ultra-small company fund that went way down with the Asian flu. So, small-value stocks went way down, and our shareholders stuck with us. What was interesting, when we got all the way back whole a year later, which was amazing that we got back that quickly, we actually did have some redemptions, and it was clearly the people that had gotten back to their previous peak they thought "oh, that was more volatility than I could handle."

So, that would be an example of real-world in that. And then the biggest one, though, is simple kind of herd following. Joe got this great stock pick last year, made a lot of money. I'm a little late, but maybe I should get in now or the Internet bubble, obviously.

Zimmerman: People like winners in sports and in stocks, as well.

Montgomery: That's right.

Zimmerman: You were referring earlier to the value premium, and there's also the small-cap effect, that over time less-expensive stocks tend to outperform more-expensive stocks, and smaller cap stocks outperform their larger counterparts.

At an earlier Morningstar Investment Conference, Jack Bogle gave a fantastic speech called "The Telltale Chart," where he looked into those things, and of course, he a great believer in the mean reversion. He looked into the time series, where in the aggregate those things are true, and showed that relatively small slivers of the time series accounted for these great premiums that people believe are going to continue into perpetuity.

Montgomery: Yes.

Zimmerman: Is it possible that that's the case with momentum, too? You look at the outperformance over a 75-year track record. How much of that 75 years really gave momentum its effect?

Montgomery: Well that's interesting, I mentioned earlier that Bridgeway's small-cap momentum fund is the only fund we have based on a single model, why is that? Normally, we like to put models together that diversify the risk of that model's buy within a fund. The reason we were willing to do that with this particular risk-adjusted momentum is the extreme consistency of outperformance.

Zimmerman: Okay, interesting.

Montgomery: So this is our single most consistent model at Bridgeway, and so we were willing to put it out there all by itself. Another reason we would do that is it's a very strong diversifier of the value style.

Zimmerman: That's right.

Montgomery: So, if you are overly dependent on value managers, which by the way after the last decade which was strongly valued, many peoples portfolios have moved that direction. Momentum style tends to be actually a much better diversifier of value than it is just straightforward growth investing.

Zimmerman: Right and a lot of the academic literature confirms exactly what you are saying. There is a way in which you can sort of use a momentum sleeve in your portfolio as a proxy or a substitute for growth, which over the same very lengthy time series, value has outperformed, growth has of course underperformed. So it's an alpha detractor in the broader sense.

John Montgomery, thank you very much for being with us today.

Montgomery: Okay. Thank you very much. I enjoyed it.

Zimmerman: For Morningstar, I'm Shannon Zimmerman.