Momentum and Market Inflection Points

In earlier Fund Spy columns, I've pointed out that even zealously fundamental investors should examine the case for one purely technical strategy: price momentum. The academic research and historical track record of this simple tactic is arresting, particularly for those who believe the most reliable way to generate outperformance is to ignore price charts and conduct labor-intensive bottom-up spadework--or to invest with fund managers who do.

Yet the history of price momentum's success merits attention from fundamentalists. As GMO quant Tom Hancock shows in a white paper titled "Momentum--A Contrarian Case for Following the Herd," between 1927 and 2009, one of the most thoroughly studied price-momentum strategies produced annualized outperformance of more than 3%, gross of fees. What's more, earning the momentum premium required just one thing: investing in the top 25% of stocks that performed best during the preceding 12 months. A slightly modified (but no more complicated) momentum strategy Hancock's paper also examines has been even more effective, outperforming by almost 4% in the period.

As impressive as the data are, fundamental investors shouldn't liquidate their portfolios or abandon beliefs that, in some market environments, hold true. Aggregate return figures, after all, roll up a vast array of outlier events into a single, easy-to-digest historical track record, one that obscures the volatility and periodic underperformance that actual investors experienced.

Cases in Point
Vanguard founder Jack Bogle has shown that the vaunted small-cap and value premiums, widely regarded as impervious-to-argument investment facts, look more like investment fables when examining the historical record in close detail.

At Morningstar's 2002 Investment Conference, Bogle pointed out that, although a sum of performance peaks and valleys between 1926 and 2002 does result in outperformance for small-cap stocks relative to large, and for value stocks relative to growth, that aggregate showing owes to relatively narrow slices of a time frame that spans more than 75 years. Remove those slices and, Jenga-like, the case for persistent small-cap and value-stock outperformance collapses into mean reversion.

One takeaway from Bogle's talk is that, with few investors able to follow any strategy religiously for seven decades or more, diversification remains vitally important.

That's true at the level of strategy, too. Momentum's track record is impressive. But investors mesmerized by its long-term results should be aware of the tactic's historical performance patterns, too, allocating their portfolios across an array of strategies that complement one another in order to buoy performance when one (or several) strategies fail.

Momentum's historical track record, after all, provided cold comfort for investors heavily exposed to it in late 2008. As the market melted down, the strategy tanked. And while momentum investors did enjoy positive absolute returns during the rally that began in March 2009, strategy purists badly underperformed the broad stock market.

Momentum researcher AQR reports a gain of 14.8% for its U.S. Large Cap Momentum Index in 2009; its U.S. Small Cap Momentum bogy earned 9.1%. Meanwhile, the S&P 500 and Russell 2000 indexes delivered gains of 26.5% and 27.2%, respectively, that year.

The Q3 Test
All strategies have an Achilles' heel; market inflection points are the built-in weakness for price-momentum portfolios. And that's true irrespective of whether the inflection point presages a sharp upward or downward turn. Any strategy predicated on investing in what has been working, after all, is virtually bound to fail when the market stages a sharp reversal.

Against that backdrop, let's look at the performance of a pair of pure-play momentum funds during a third quarter that's seemingly packed a market cycle's worth of inflection points into just a few short weeks.

In addition to its topnotch momentum research, AQR runs funds based on its work; the shop's  AQR Momentum (AMOMX) is among the industry's purest momentum vehicles. In the quarter to date through Aug. 25, that large-growth offering has shed 15.8% of its value while the Russell 1000 Growth Index has fallen 11.5%. Similarly,  AQR Small Cap Momentum (ASMOX), a small-blend offering, has shed 20% on the quarter, underperforming the Russell 2000 and Russell 2000 Growth indexes by 1.6 and 1.1 percentage points, respectively.

Big Mo
Painful though these funds' recent results are, the only thing even somewhat surprising about them is that AQR Small Cap Momentum hasn't lagged by an even wider margin. If the third quarter of 2011 turns out to have been a genuine market inflection point, history suggests that gap will grow larger.

Yet the persistence of price momentum's outperformance over the long term, across style and most geographic boundaries as well, is reason to think there may be more success where that came from. Before diving into any pure-play momentum fund, though, investors should consider not only the strategy's historical long-term results but its likely performance pattern as well.

Amid the ebb and flow of the market cycles investors will experience, a detailed view of momentum's rocky track record, not merely its neatly rolled-up historical results, provides information they'll need to either stick with or avoid altogether a strategy that, like others, won't shine in every market environment.