Christine Benz: Hi, I'm Christine Benz for Morningstar.com. Momentum has been one of the most persistent market anomalies. Joining me to discuss the momentum effect and how one might incorporate momentum strategies into a portfolio is Alex Bryan. He is director of passive strategies research for North America for Morningstar.
Alex, thank you so much for being here.
Alex Bryan: Thank you for having me.
Benz: Alex, let's discuss the momentum effect. Why do market researchers think it's this persistent force in market behavior?
Bryan: Sure. So, momentum is basically tendency of recent performance to persist. So, for example, stocks that have outperformed over the past six to 12 months tend to continue to outperform over the next several months to a year, and that effect has been pretty pervasive. This is a pretty blatant violation of what you would expect if the market were efficient.
So, there has been a lot of research done with investor behavior, and one of the leading theories to explain why this effect occurs is that there's some behavioral biases. So, first, investors may underreact to new information because they anchor their investment thesis to information they already know and may not fully appreciate the magnitude of new information as it gets released into the market. Now that can cause market prices to react more slowly than they should to new information.
Secondly, a lot of investors are reluctant to sell stocks that have gone down in price. They are holding on to those names in the hopes of breaking even, and they may sell their winners prematurely to lock in gains. So that again can cause prices to react more slowly than they should to new information.
The third effect at work may be that investors, once a pricing pattern has been established, once the trend has been established, may pile into a trade in hopes of latching on to some of the excess returns, and that hurting behavior can potentially push prices away from the fair value, potentially leading to some of these longer-term reversals that we see with the value of that. So, it's kind of all these different forces at work, but initial underreaction and potentially longer-term overreaction.
Benz: So, let's talk about how strong the evidence is behind this momentum effect. It's not just a U.S. market phenomenon, correct?
Bryan: That's right. In fact, momentum is one of the most pervasive forces in finance. So, we've observed it first in U.S. stocks, but the same effect has been observed in international markets and not only in stocks but also in other asset classes, bonds, currencies, commodities, and even at the index level. So that's pretty amazing. No matter how you, kind of, define momentum, it's there. And I was skeptical when I first learned about the momentum effect, but I've done a bit of research on my own and no matter how I look at it, it's pretty clear in the data that it's a pervasive effect.
Benz: So, let's get into your research. You did a piece in Morningstar ETFInvestor where you looked at a momentum-oriented strategy using indexes, not individual stocks, using whole indexes tracking specific sectors. Let's talk about how you went about your research in an effort to prove or disprove the momentum effect.
Bryan: So, I actually set up three different strategies: One was a sector rotation strategy; one was a country rotation strategy; and then I had an asset class rotation strategy, again to try to test how robust this effect is in the strategy. So, basically, I set up a very simple strategy where I took 10 different sector indexes. I used the Dow Jones indexes because the data went back the farthest. And I ranked these indexes based on the returns over the prior 12 months, and I selected three indexes that had the best returns over the past 12 months and then I held that portfolio for a month and then I rebalanced and repeated. That strategy was remarkably successful for the sector rotation strategy as well as the country and asset class rotation strategy. I made some adjustments to the country strategy because there were more indexes. But by and large, it was a same strategy and it worked very, very well, on paper at least.
Benz: So, investors might be captivated by this idea of outperforming kind of a buy and hold strategy. But let's talk about some practical headwinds for momentum investing. Even though there is a lot of academic data to support it and your recent research supports it, let's talk about some things that can cut into that return edge that you might earn as an investor.
Bryan: And that's a very important point. On paper this looks good, but momentum requires very high turnover and that can create high transaction cost and low tax efficiency that can really erode these returns in practice. So, these paper returns that I'm talking about aren't necessarily returns that investors would be able to get if they put this strategy to work. So, high transaction costs are a big problem but there are some adjustments that you can make to the strategy to try to make it a little bit more efficient.
So, for example, rather than rebalancing this portfolio once a month I made an adjustment where I would only rebalance it once a quarter. That reduces the number of transactions that you actually have to make. Secondly, concentrating this type of strategy at the index level helps because each index is fairly well-diversified, so you're not having to trade in and out of as many names as if you had applied the strategy to individual stocks.
But another adjustment that you can make to the strategy is applying the buffering rule. So rather than just targeting the top three indexes, you could say, you know what, as long as an index ranks in the top four of the 10 indexes that I'm ranking, I'll still hold that. That's a buffering approach that a lot of indexes use themselves to try to mitigate unnecessary turnover, and between the two adjustments--rebalancing quarterly and putting that buffering rule into place--the amount of required turnover was cut down substantially with the strategies that I tested.
Benz: Apart from the costs that you just talked about and ways to potentially reduce them, I guess complexity would be another potential headwind for investors attempting to implement such a strategy. So, are there products that try to harness momentum? Are there any ones that you and the team like that use kind of a momentum-oriented strategy and perhaps simplify this whole effort for an individual investor?
Bryan: Well, there are. The one strategy that applies this type of momentum framework to indexes--and specifically it uses ETFs to do that--is a fund called Cambria Global Momentum ETF, ticker is GMOM. And what this does is, it ranks 50 different ETFs, these include stock ETFs, bond ETFs, currency and commodity ETFs, and it ranks them based on their relative momentum as well as their absolute momentum, and it tries to target the third that have the best momentum. So that makes it easier for investors who don't want to do this themselves, they can simply hold that product, and because it's using this ETF wrapper that helps with some tax-efficiency issues that you may have if you try to do it yourself.
There's also some momentum ETFs that apply the strategy to stocks. One of my favorites is the iShares MSCI USA Momentum Factor ETF, ticker MTUM. That charges a low 15 basis points expense ratio and is pretty well diversified. So, I think for investors who don't have the inclination or the discipline to apply this strategy on their own, one of those products might be a good solution.
Benz: Alex, thank you so much for being here to discuss this research and to share your insights.
Bryan: Thank you for having me.
Benz: Thanks for watching. I'm Christine Benz for Morningstar.com.