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By Shannon Zimmerman | 10-05-2012 12:00 PM

Bhansali on the Benefits of Price Momentum

PIMCO's Vineer Bhansali sees price momentum as a means to enhance portfolio construction as well as hedge against risk.

Shannon Zimmerman: In the fund research group here at Morningstar, we're fundamentally focused, but a lot of us have interest in quantitative analysis, as well. So, I am very excited to talk to you in your capacity as the person who oversees PIMCO's quantitative portfolios.

So, talk a little bit about the inputs that you use there and then sort of drill down if you would on price momentum. My question there is why such a simple strategy? If you look at the Carhart method which is really just 12 months of what's done well and then you back out I think the last of the 12 months' returns and then re-sort, and there are your contenders and you just buy those, the track record over a very lengthy time series is remarkably impressive. Why hasn't such a simple strategy been arbitraged away?

Vineer Bhansali: I think the reason it hasn't been arbitraged away, and we'll go backwards here on your question, is because it has to do with behavior of participants. And in equities, information about stocks that's available to most market participants is not particularly long, and as a matter of fact, when they react to it, they are looking at recent price behavior and saying, "What's been going up? Let's buy what's been going up." And this can be traced back to our own behavioral biases. We look to anchor our expectations to what has recently happened, or representation of what has recently happened drives our behavior.

So, it works. It works, and the reason it hasn't been arbitraged away is because people's behavior cannot really be arbitraged away unlike real cheap opportunities in equities or in bond land where you can buy something and sell something else. You really can't short out something else that'll give you a risk-free profit against momentum. So, there are theoretical reasons why momentum doesn't get arbitraged away. We have found, like others, have that momentum doesn't just exist in equities where you can do quintiles of longs and shorts based on momentum risk factors, but you can also do it across asset classes, you can do it across commodities and you can do it across interest rates, you can do it across...

Zimmerman: Regional boundaries, as well.

Bhansali: Exactly, and momentum is a very pervasive common factor. And one of the interesting ways we’ve been using it for multiple years is as a diversifier. What we found is that when the bounds of mean reversion break, when valuation becomes less important and this usually happens when people start to romance a possible bimodal outcome in our speak or a potential fat-tailed outcome, the bounds of mean reversion break and markets start to trend. And that’s when the momentum risk factor really shines, for example, in 2008 right during the financial crisis. So we think of momentum not as an investment asset, but as a risk factor, and that’s consistent with our overall risk factor approach to asset allocation. And we do use it as a cyclical risk factor to allocate both for risk management reasons, as well as for portfolio enhancement.

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