For example, there’s ample evidence that investors underreact to corporate earnings and dividend announcements. Delayed overreaction results from investors who chase returns provide a feedback mechanism that drives prices further away from fundamentals, causing momentum in the short term that is eventually reversed when prices correct themselves in the long-term. Herding leads to the same phenomenon.
The risk-based explanations however seem counterintuitive—after all, the risk of an asset would have to increase after positive returns. Yet several papers posit the risk version of this story.
Moskowitz summarized the risk account of the momentum premium from these papers: “Past winners face greater risk going forward either because their growth prospects have now been identified as more risky or they face greater beta (market) risk than before because their investment opportunities have been adjusted. In either case, a firm that has recently experienced a huge rise (fall) in returns over the past year will now face a higher (lower) cost of capital because their cash flow risks and/or risk exposures have increased (decreased).”
The risk explanations for the value premium seem more intuitive—when prices drop, we think a security becomes riskier due to a lot of simple, logical reasons. It’s much harder to give an explanation of the momentum premium that includes risk increasing after prices went up.
As we have discussed, there is a wealth of both risk-based and behavioral-based explanations for the momentum and value premiums. The jury is certainly still out on which of these explanations have the most merit. And it’s possible that the truth lies somewhere in between. While academics continue to debate this issue, the distinction between risk and behavioral explanations is less relevant for investors.
What’s important is that, in either case, there are good reasons for the premiums to persist. If the premiums are risk-based, they cannot be arbitraged away. If the premiums have a behavioral cause, as long as the biases and behaviors underlying them remain stable, they are also likely to continue. Remember, both the value and momentum premiums have persisted for decades even after their “discovery.”
The main question for investors is whether they can obtain exposure to these premiums at low costs. The answer to that is yes. There are certainly plenty of providers of low-cost value funds. And there are even low-cost, passively managed funds from Bridgeway and Dimensional Fund Advisors that incorporate momentum into their value strategies. (Full disclosure: My firm, Buckingham, recommends Dimensional and Bridgeway funds in constructing client portfolios.)
What’s more, there are low-cost providers of ETFs that focus on the momentum premium. For example, the iShares MSCI USA Momentum Factor (MTUM | A-59) ETF has an expense ratio of just 0.15 percent. It currently has about $325 million in assets under management.
In addition, hedge fund manager AQR has introduced several momentum-oriented mutual funds with reasonable fees ranging from 0.49 percent to 0.65 percent. They offer a U.S. large-cap momentum fund (AMOMX), a U.S. small-cap momentum fund (ASMOX) and an international momentum fund (AIMOX). They also have tax-managed versions of the same three funds.
The bottom line is that momentum is a unique, independent factor. Regardless of the root cause of this phenomena, adding exposure to this factor seems likely to improve the returns of virtually any investment portfolio.
Larry Swedroe is the director of research for the BAM Alliance, a community of more than 140 independent registered investment advisors throughout the country.