• Gray and Vogel introduce the theory behind momentum, what drives the effect, why it should persist, and how to build an improved quantitative momentum strategy that exploits the sustainable edge in investor misbehavior.

• A momentum strategy is simply: buying winners.

• Value and momentum strategies are tied to expectation error (from a behavioral viewpoint). Momentum strategies work because of underreaction to positive news, value strategies because of overreaction to negative news. That’s where the similarities end. Value’s focus is on fundamentals to assess price versus intrinsic value. Momentum’s focus is on price.

• Any “anomaly” strategy will continue to work as long as:

  • Investors, on average, exhibit behavioral biases.
  • Investors remain short-term performance chasers.

• In other words, build strategies around areas where investor misbehavior and fund manager incentives (like career risk) or frictions endure.

• Time-Series Momentum: Or absolute momentum, is based on a stock’s past return, independent of other stocks.

• Cross-Sectional Momentum: is based on a stock’s past return, relative to other stocks.

• “Behavioral bias + Market frictions = Mispriced assets.”

• Behavioral-based strategy framework:

  • Identify areas mispricing due to behavior driving prices from fundamentals.
  • Identify incentives and frictions where fund managers are unable or unwilling to act due to high arbitrage costs.
  • Identify areas were high mispricings and high arbitrage costs overlap (where arbitrage costs are high for the majority of managed capital, but low for the individual investor).
  • Build a good process to exploit it.

• An example of high arbitrage costs can be found in career risk: relative underperformance increases career risk. Think of a fund manager who’s decisions are aligned with keeping their job (or avoid losing clients) instead of finding mispriced opportunities because mispriced opportunities bring a higher risk of deviating from the market return in the short term. The higher cost of job loss in the short term outweighs the importance of higher long term returns.

• “The next time you hear a market participant suggest that one strategy is better than another strategy, simply ask two basic questions: (1) Why are the securities selected by this process mispriced? and (2) Why aren’t other smart investors already exploiting the mispricing opportunity? Without solid answers to both questions, it is unlikely that the investment process is sustainable.”

• Momentum Basics:

  • Research shows that stocks that performed well over the past year, continue to do so in the future.
  • Persists when controlled for size and value.
  • Works across asset classes, countries, commodities, currencies, and bonds.
  • Robust across time (one study found the effect going back 200 years).
  • Uncorrelated with value, offering a diversification benefit.

• “We use the term momentum to mean a continuation of past relative returns — past winners tend to be future winners, while past losers tend to be future losers.”

• The disposition effect — the tendency to sell assets that rose in value (while holding assets that fell in value) — might explain momentum. In effect, investors lock in gains too soon. They fail to let their winners run.

• “Perhaps momentum investing’s edge could be characterized as pessimism in the presence of strong short-term fundamentals, which causes stocks to remain too cheap to future expectations.”

• Momentum is not the same as growth.

• Comparing monthly randomly drawn top “growth” versus “momentum” stocks, momentum outperformed growth on average over a 50 year period, with significantly lower drawdowns.

• Momentum stocks can be growth stocks, value stocks, quality, low-vol… Unlike value, growth, quality, etc., fundamentals don’t factor into momentum stocks at all. High momentum is based on price action alone.

• “Momentum investing works because the relative strength indicator is a proxy for a systematic expectation error in the market that predictably reverts in the momentum investor’s favor, on average.”

• Momentum (high Mom) beats value (high B/M), growth (low B//M), and the broad market based on Ken French data.

• Value and momentum are driven by opposites sides of a similarly biased coin. Value by overreaction — investors are too quick to update views based on new data. Momentum by underreaction — investors are too slow to update views based on new data.

• Momentum, like any solid strategy, requires discipline because it fails to work all the time. Multi-year periods of market underperformance are likely. The seven-year period of underperformance from 2008 to 2014, is a recent example.

• “Momentum-based stock selection strategies won’t provide extreme insurance-like diversification benefits, but momentum strategies can pack a punch as it relates to overall diversification. For example, long-only momentum strategies are not perfectly correlated to the broad equity market, and they have low correlations with classic value strategies. These features make momentum strategies highly desirable in a portfolio context when they are pooled with value strategies.”

• How to calculate “momentum”? Momentum for a stock is the stock’s total return w/ dividends over a specific period, like the past 12 months. (A generic momentum strategy is built: sort stocks by highest “momentum,” then seed portfolio with the top 30, 50, 100, etc. stocks.)

• Short-term Momentum:

  • Uses, at most, a 1-month look-back period.
  • Studies show last week’s winners are this week’s losers and vice versa.
  • Also, last month’s winners are this month’s losers and vice versa.
  • A portfolio rebalanced monthly showed the prior month’s losers beat the winners by a 9% annual return.
  • In other words, prior short term winners become losers and losers become winners in the near future.

• Intermediate Momentum:

  • Uses a 6 to 12-month look-back period.
  • Studies show that winners stay winners and losers stay losers.
  • But the effect dissipates after a short while before ultimately reverses (see long term momentum). In other words, using intermediate-term momentum but then held long term results in worse performance.
  • A portfolio rebalanced monthly showed intermediate-term winners beat losers by an almost 18% annual return (also beat the market).
  • “…portfolios formed on intermediate-term momentum exhibit a continuation of returns… However, as we discussed earlier, this “continuation” effect does not work if we just buy-and-hold intermediate-term momentum stocks. We must form the portfolio so that the rebalance frequency can capture the abnormal returns associated with the approach.”

• Long-term Momentum:

  • Uses a 3 to 5 year (60-months) look-back period.
  • Studies show over 3 and 5 year periods, the winners became the losers, and vice versa.
  • A portfolio rebalanced monthly, based on previous 5-year performance, showed prior long-term losers beat the winners by a roughly 5% annual return (also beat the market).

• “As a general rule, and putting transaction costs aside, the more frequent a portfolio is rebalanced, the better the performance.”

• The intermediate momentum portfolio examples use a 12-month look-back period but only use the first 11 months for the momentum calculation. The last month is ignored to account for the short-term momentum reversal effect. However, the authors’ state, including the last month does not significantly alter results.

• Varying the holder period and portfolio concentration: returns improve with a shorter holding period and a higher concentration of stocks (shortest holding period tested was 1-month with a concentration of 50 stocks).

• Possible improvements to a simple momentum strategy:

  • “Smooth” versus “Choppy” Momentum: compare the percentage of days with a positive return relative to days with a negative return. “Smooth” momentum stocks have a higher percentage of positive return days and tend to perform better than “Choppy” momentum stocks.
  • “Boring” versus “Lottery” Momentum: compare average daily return in the past month. “Boring” momentum stocks have a lower average daily return over the past month and tend to outperform “Lottery” momentum stocks.
  • A proxy for “Boring” versus “Lottery” is low beta versus high beta, where low beta = boring.
  • “…momentum profits are larger for stocks with low analyst coverage and for small stocks.”

• “Human beings suffer from an inability to properly weigh their chances of success for low-probability events. In other words, humans predictably overestimate their chances of winning the lottery.”

• On seasonality effects: “One needs to be skeptical of seasonality-type claims.”

• That said, the authors argue for a momentum strategy (by rebalancing before quarter-ending month) built around the effects of quarterly window dressing and year-end tax-loss selling. The backtested returns weren’t significantly different enough from a generic mom strategy to be convincing (a 0.48% difference in returns).

• Window Dressing: the act of fund managers to fill their funds with “winning” stocks before the end of a quarter when holdings are reported. The idea being, dressing up their portfolio with “winners” (while selling “losers”) helps retain clients.

• Tax Loss Selling: the theory is that year-end tax-loss selling leads to a new year buying spree or the “January Effect.”

• Equal weighting a generic momentum strategy boosted returns by 2.4%, benefiting from diversification and small-cap effect.

• “We must emphatically emphasize that investors need to be prepared for the enhanced volatility and drawdown risks associated with momentum strategies — that is a primary reason why this system is expected to work in the future — but this enhanced risk is more than offset by additional expected returns, which is what makes momentum anomalous.”

• Analyzing Backtested Maximum Drawdowns: helps answer the question of how much can I lose? Using rolling drawdowns (5-year, 10-year) helps compare the frequency of big drawdowns between multiple strategies.

• “At the pinnacle point of pain, when the most disciplined and hardened active investors earn their keep, the active investor with a clear mind, thorough understanding, and a strong conviction for their process will win. Those who do not fully understand why a process works are more likely to provide the active alpha to the clairvoyant investor who can hold on to an active portfolio like grim death.”

• Portfolio Construction Ideas:

  • A combo portfolio split 50/50 between a concentrated value strategy and momentum strategy (rebalanced quarterly) improved performance while reducing the longer periods of underperformance achieved in a value or momentum strategy alone.
  • Adding a trend strategy to the combo value/momentum portfolio reduces large drawdowns significantly, but comes with a cost of a slightly lower return. (Used a simple moving average rule: S&P 500 Total Return Index – S&P 500 12-month moving average > 0, go long the combo, otherwise, go long T-bills.)
  • Core-Satellite Approach: the “core” portfolio is a passive strategy, with a small percentage — the “satellite” — dedicated to an active strategy, like an 80/20 allocation to core/satellite. It gets a slight improvement over market returns at a minimal cost.

• “If one is going to deviate from a passive index, and pay extra management fees, embrace active risk and pay up for concentration, not closet-indexing.”

Quotes

“We must emphatically emphasize that investors need to be prepared for the enhanced volatility and drawdown risks associated with momentum strategies — that is a primary reason why this system is expected to work in the future — but this enhanced risk is more than offset by additional expected returns, which is what makes momentum anomalous.”

“Human beings suffer from an inability to properly weigh their chances of success for low-probability events. In other words, humans predictably overestimate their chances of winning the lottery.”

“If one is going to deviate from a passive index, and pay extra management fees, embrace active risk and pay up for concentration, not closet-indexing.”

“The next time you hear a market participant suggest that one strategy is better than another strategy, simply ask two basic questions: (1) Why are the securities selected by this process mispriced? and (2) Why aren’t other smart investors already exploiting the mispricing opportunity? Without solid answers to both questions, it is unlikely that the investment process is sustainable.”

“We use the term momentum to mean a continuation of past relative returns — past winners tend to be future winners, while past losers tend to be future losers.”

“Momentum investing works because the relative strength indicator is a proxy for a systematic expectation error in the market that predictably reverts in the momentum investor’s favor, on average.”

“Momentum-based stock selection strategies won’t provide extreme insurance-like diversification benefits, but momentum strategies can pack a punch as it relates to overall diversification. For example, long-only momentum strategies are not perfectly correlated to the broad equity market, and they have low correlations with classic value strategies. These features make momentum strategies highly desirable in a portfolio context when they are pooled with value strategies.”

“If one is going to deviate from a passive index, and pay extra management fees, embrace active risk and pay up for concentration, not closet-indexing.”

References

• novelinvestor summary