Research Affiliates: How NOT To Wipe Out With Momentum

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.