How NOT to wipe out with momentum

September 29, 2015

4 minute read

How NOT to wipe out with momentum

by Chris Brightman, CFA, Vitali Kalesnik, Ph.D., and Engin Kose, Ph.D., Research Affiliates

KEY POINTS

1. Implementation costs and front running make an index replication strategy inadvisable as a means to capture the momentum premium.

2. The pros (proven profitability and robustness) of momentum can swiftly be wiped out by the cons (crashes and crowded trades), making an active implementation dangerous for all but the most skilled managers.

3. Combining value and momentum in order to exploit their typically negative correlation in stock holdings and alpha can improve a portfolio’s Sharpe ratio over those of either strategy alone.

Momentum investors are like the surfers we watch from beaches along the Pacific coast. Both must catch a wave. Both attempt to ride it as it breaks. But the ability to glide away smoothly before being caught inside the inevitable crash(ing wave) that follows is what determines success.

Momentum, one of a handful of equity factors that empirically displays robust equity returns, has recently become popular as investors explore factor investing. In the passive realm, investors are increasingly seeking to replicate cheap and transparent indices. But does index replication make sense in the case of momentum? We believe a momentum strategy implemented through an index-based approach has serious limitations. And although some active managers are quite adept at riding the momentum wave, it does require significant experience and skill. Our view is that momentum as an index replication strategy can be very dangerous, but incorporating it into an active value strategy is an opportune way to exploit its insights.

Catching the Wave

The investment industry borrowed the term “momentum” from the physical sciences. In physics, momentum is defined as mass (such as ocean water) in motion. When used in the sense of investing, momentum refers to movement in stock prices. Several explanations exist for the energy that creates the prolonged movement of stock prices higher or lower. The most convincing explanation in our view is that investors initially underreact to earnings surprises. Chordia and Shivakumar (2006) and Novy- Marx (2015) have shown that earnings momentum explains most of the momentum effect. Investors are at first slow to react to an unexpected uptick or downtick in earnings.

But when the next earnings data are reported and they confirm the prior report, investors register the potential importance of the change in trend. If earnings are higher than expected, the momentum in price is upward. Subsequent confirming earnings releases may even cause euphoria and over-extrapolation of future earnings forecasts, reinforcing the fast-moving upward trajectory. The momentum investor benefits as the price reacts to subsequent earnings announcements and moves higher. Price momentum can also move in the opposite direction—down—with correspondingly negative outcomes for investors. We will discuss this “fly in the sunscreen” in the next section.

Investors have good reason to want to catch the momentum wave. History shows that stocks with above-average performance in the prior year have tended to persist in producing short-term excess returns. This tendency is one of the strongest empirical regularities in finance and has been documented across geographies and asset classes.

Table 1 reports the average performance of momentum equity portfolios constructed for different definitions of momentum1 and in different geographical markets: the United States, Europe, Japan, Asia Pacific ex Japan, and Global.

Momentum has consistently added value across markets, with the widely known exception of Japan, an outlier we would expect for any strategy with inherent randomness.

The data also show that the risk–return characteristics of momentum are robust across time periods. Figure 1 plots the growth of one U.S. dollar invested in a long–short momentum strategy in January 1927. By the end of the 87-year period in June 2015, it had grown quite steadily to a formidable $6,524, which compares to $4,078 for the market portfolio.

Wiping Out

Buying into positive price momentum— that is, purchasing a stock whose price subsequently and steadily rises—generates a capital gain for an investor. The catch is that, as in physics, what goes up must come down. The perfectly breaking 15-foot wave can quickly become dangerous and deadly.

Predicting when that turning point will be, just as forecasting when the turning point in the price momentum of a particular stock or asset class will arrive, is no easy task. Missing that turning point can mean not only not locking in a gain, but more insidiously being “caught inside the wave,” unable to sell before the downside of a momentum trend takes hold in the market. Accordingly, two predominant risks characterize a momentum strategy: substantial drawdowns, or crashes, and a crowded momentum trade, which makes the trading costs high enough to obliterate the alpha of the strategy for the careless momentum surfer. Let’s take a closer look at both of these.

The crashes periodically experienced in a momentum strategy can be significant, as Figure 2 shows. The relentless upward climb of prices depicted in Figure 1 disguises (thanks to the log-scale of the chart) the sudden and abrupt drawdowns that a momentum investor must live with. These drawdowns usually occur following periods of heightened volatility, typically a function of a crisis event.

Since 1927, drawdowns have generally been under 20%, but the granddaddy of all drawdowns was the 74% plunge in prices in the aftermath of the Great Depression. In the last 15 years, the U.S. equity market has been visited with two major negative momentum events: the first, a 31% drawdown after the tech bubble burst in 2000, and the second, a 57% drawdown, in the wake of the 2008 global financial crisis.

In a crash, the price momentum is typically concentrated in groups of stocks that the market particularly loathes and fears more than others, often distressed companies with high betas. These recent losers are sold as the negative momentum continues, until investors, satisfied with the new state of the world, view these stocks as cheap enough to be great investment opportunities. As the market shifts its perspective, the most-feared losers with high betas recover with a vengeance and momentum investors are off to catch another wave.