Momentum is the tendency for assets that have performed well (poorly) in the recent past to continue to perform well (poorly) in the future, at least for a short period of time.
This is a big problem for the efficient markets hypothesis, as there’s no coherent risk-based explanation for momentum’s performance. Not only has there been a sizable momentum premium in stocks (larger even than the market beta premium), but its Sharpe ratio has been higher.
In addition, the research demonstrates that the premium has been persistent across time periods and economic regimes; pervasive across global equity markets as well as across bonds, commodity and currency markets; robust to various definitions; and it has been shown to be implementable (meaning it survives transaction costs).
Misunderstood Momentum Factor
Despite an extensive body of evidence on the momentum premium, both cross sectional (relative momentum) and times series (absolute momentum, or trend-following), it remains misunderstood by most investors. So authors Wesley Gray and Jack Vogel provide a great service to both individual retail investors and practitioners with their new book, “Quantitative Momentum.”
The first part of the book provides, in layman’s terms, an excellent summary of the academic research on the momentum premium. Importantly, it also provides explanations from the field of behavioral finance that explain not only why this anomaly exists, but why it is likely to persist even though it has become well-known through the publication of numerous academic papers.
Cycle Of Underperformance Evident
The behavioral explanations are important because, without such an understanding, investors can’t develop a strong belief system. And because all systematic investment strategies (including momentum) may experience very long periods of poor performance, without a strong belief system, investors are likely to abandon the strategy when poor performance persists, even for relatively short periods (such as three or five years). In the data they offer, Gray and Vogel show momentum can indeed experience periods of large drawdowns and long periods of underperformance.
Gray and Vogel also demonstrate momentum not only works in isolation, but because of its negative correlation with the value factor, momentum works even better in combination with value.
They show this combination provides both a higher Sharpe ratio and reduces downside risk, an important feature since investors tend to feel the pain of a loss much more than they do the joy of an equal-sized gain. It’s also an important feature for investors in their withdrawal phase, when the order of returns can matter greatly.
Furthermore, Gray and Vogel demonstrate various alternative momentum strategies, providing insight into how momentum can be incorporated into portfolios. Despite the strong evidence from published research, momentum has not gotten the attention it deserves. Gray and Vogel correct that problem.
They bring momentum out of the “black box” world of hedge funds and into the light by showing how incorporating momentum can lead to more efficient portfolios. In short, anyone interested in learning ways a systematic approach to incorporating momentum into their portfolio can add value should read this very comprehensive and well-written book.
Larry Swedroe is the director of research for The BAM Alliance, a community of more than 140 independent registered investment advisors throughout the country.