Keeping Up With Momentum Investing

Christine Benz: Hi, I'm Christine Benz for Morningstar. What role, if any, should momentum strategies play in investors' portfolios? Joining me to discuss that question is Alex Bryan. He's Morningstar's director of passive strategies research in North America. Alex, thank you for being here.

Alex Bryan: Thank you for having me.

Benz: Alex, you wrote about momentum investing in the latest issue of ETFInvestor. Before we get into that discussion, can you just define what momentum investing is?

Bryan: Momentum is based on the premise that recent performance tends to persist. In other words, stocks that have recently outperformed continue to outperform in the short term. Now, this has been a very widely documented phenomenon, and I think one of the best explanations for it is that investors are slow to react to new information. And that causes prices to adjust more slowly to new information than they otherwise should, and that can create persistence in performance. Now, once a trend has been established, you might have more investors pile into the trade, and that can push prices away from their fair value, leading to those long-term reversals that we see behind the value effect. But in the short term, we notice that performance tends to persist on average.

Benz: A followup question is, we're often telling investors not to performance-chase, that that rarely leads to good outcomes. Can you explain the disconnect why, say, performance-chasing mutual funds is not a good idea, but momentum strategies might have legs in other situations?

Bryan: That's a great question. Long-term performance-chasing is really where investors get into trouble. Momentum is a short-term phenomenon. We're talking about performance over the past six to 12 months continuing over the next six to 12 months. But a lot of times when investors chase performance in mutual funds, they're looking at a manager that has a really strong multiyear record, strong performance over the last three to five years.

Now, if you buy into a strategy that has really strong performance over a longer time period, odds are you're not getting momentum, you're buying into stocks that are very expensive and perhaps priced to offer lower returns going forward. So in the long term, we see mean reversion in performance--things that outperform long enough eventually become expensive and priced to offer lower returns going forward. But in the short term, there tends to be a continuation of the trends. So it's really important to have the right time frame in mind. And if you're going to do this, it's best to invest in a strategy that does it for you, so you don't have to worry about maybe messing up the implementation.

Benz: While momentum strategies might look good on paper, you note that sometimes there can be challenges with implementation. Let's talk about some of those.

Bryan: Implementation certainly does matter. One of the key challenges in translating this academic research into practice is that transaction costs are very real for momentum strategies. These strategies require very high turnover, which can be expensive for the funds that are actually trading these stocks. It can also lead to poor tax efficiency. So those are the most notable problems.

On top of this, momentum strategies tend to struggle during periods of high market volatility, like what we saw earlier this year. And if you think about that, it makes sense because in the late stages of a market rally, momentum strategies often will overweight more-cyclical names. And those names are the ones that get hammered the most during market corrections. And then coming out of a correction, they often overweight more-defensive names and miss out on the early stages of the recovery. So implementation absolutely matters, and I think some funds approach it better than others.

Benz: One thing I sometimes read is that the S&P 500 or any other index that is constructed according to capitalization weighting is, in effect, a momentum strategy. What do you say to that assertion?

Bryan: It depends on what your reference point is. If your reference point is the market, what all investors own in aggregate, well, then by definition you're not getting anything distinctive there. But if you were to compare a market-cap-weighted index to an alternative, let's say, an equal-weighted version of the Russell 1000, for example, then there is some truth to the fact that the market-cap-weighted strategy allows the winners to run and may have a little bit of momentum exposure in there. But I will emphasize that even against an equal-weighted benchmark, it is a very modest exposure to momentum. And if you're really looking to harness this anomaly, the best way to do that is with a fund that explicitly targets stocks that have strong momentum relative to other stocks. I think that's really the best way of capturing this.

Benz: Are there any momentum funds or ETFs that you like?

Bryan: There's one that we do like quite a bit. It's the iShares MSCI USA Momentum Factor ETF. Ticker is MTUM. This fund basically looks for stocks that have strong risk-adjusted performance. And I think that focus on risk-adjusted performance is important, and it helps this fund during choppy market periods because it's less likely to load up on more cyclical names during market rallies or defensive names during downturns. That can help performance when the market turns.

The other thing I really like about the strategy is that it puts some smart buffers in place to mitigate unnecessary turnover. Now, that can slightly dilute the fund's style purity, but when you're translating momentum into practice, I think the reduction in transaction costs and the improvement in tax efficiency are well worth it.

Finally, I note that this fund has yet to distribute any capital gains. It's been very tax-efficient, and it's also very cheap. It charges a low 15-basis-point expense ratio. So it has a very low cost hurdle to overcome. So I'd say as far as momentum strategies, this is certainly one of our favorites. It currently carries a Morningstar Analyst Rating of Silver.

Benz: Alex. It's always great to get your perspective. Thank you so much for being here.

Bryan: Thank you for having me.

Disclosure: Morningstar, Inc. licenses indexes to financial institutions as the tracking indexes for investable products, such as exchange-traded funds, sponsored by the financial institution. The license fee for such use is paid by the sponsoring financial institution based mainly on the total assets of the investable product. Please click here for a list of investable products that track or have tracked a Morningstar index. Neither Morningstar, Inc. nor its investment management division markets, sells, or makes any representations regarding the advisability of investing in any investable product that tracks a Morningstar index.