Swedroe: A Close Look At Value & Momentum

Combining factors like value and momentum with gross profitability improves portfolio efficiency.

Reviewed by: Larry Swedroe
Edited by: Larry Swedroe

Combining factors like value and momentum with gross profitability improves portfolio efficiency.

Two of the most studied capital market phenomena are the value effect, where value stocks outperform growth stocks; and the momentum effect, where recent relative performance predicts near-term returns.

Clifford Asness, Tobias Moskowitz and Lasse Pedersen add to the body of literature on this topic with their paper, “Value and Momentum Everywhere.” The study, which appeared last year in The Journal of Finance, examined the value and momentum effects across eight different markets and asset classes—individual stocks in the U.S., the U.K., continental Europe and Japan, as well as country equity index futures, government bonds, currencies and commodity futures.

The following is a summary of their findings:

  • There are significant return premiums for both value and momentum in every asset class. The value premium was persistent in every stock market, but demonstrated its strongest performance in Japan. The momentum premium was also positive in every market, especially in Europe, although statistically insignificant in Japan.
  • Value strategies are positively correlated with other value strategies across otherwise-unrelated markets, and momentum strategies are positively correlated with other momentum strategies globally. This persistence assuages data mining concerns.
  • Value and momentum are negatively correlated with each other within and across asset classes. The negative correlation between value and momentum within each asset class is consistent and averages -0.49. For stocks, the correlation averaged -0.60. The negative correlation between value and momentum and high positive expected returns imply that a simple combination of the two is much closer to the efficient frontier than either strategy alone. Combining strategies results in improved Sharpe ratios.
  • There’s significant evidence that liquidity risk is negatively related to value and positively related to momentum globally across asset classes. The implication is that part of the negative correlation between value and momentum is driven by opposite-signed exposure to liquidity risk. However, liquidity risk can only explain a small fraction of value and momentum return premiums and co-movement.

The paper’s authors offered this explanation for why momentum loads positively on liquidity risk and value loads negatively:


“A simple and natural story might be that momentum represents the most popular trades, as investors chase returns and flock to the assets whose prices appreciated most recently. Value, on the other hand, represents a contrarian view. When a liquidity shock occurs, investors engaged in liquidating sell-offs—due to cash needs and risk management—will put more price pressure on the most popular and crowded trades, such as high momentum securities, as everyone runs for the exit at the same time, while the less crowded contrarian/value trades will be less affected.”

While this study, like most academic papers, focused on gross returns, the November 2012 study, “Trading Costs of Asset Pricing Anomalies,” written by Andrea Frazzini, Ronen Israel and Tobias Moskowitz, found that value and momentum strategies can be scaled considerably and still generate strong net returns.

The bottom line here is that the evidence is piling up. Investors can improve the efficiency of their portfolios by using investment vehicles that incorporate value and momentum strategies. And with the publication of Robert Novy-Marx’s paper “The Other Side of Value: The Gross Profitability Premium,” we have strong evidence that combining this third factor, the gross profitability premium, with value and momentum improves portfolio efficiency even further.

One set of funds implementing these concepts are the AQR Core Equity Funds (QCELX, QSMLX, QICLX), which were launched in March of last year. These funds offer direct exposure to the combination of value, momentum and profitability.

Larry Swedroe is the director of Research for the BAM Alliance, a community of more than 130 independent registered investment advisors throughout the country.

Larry Swedroe is a principal and the director of research for Buckingham Strategic Wealth, an independent member of the BAM Alliance. Previously, he was vice chairman of Prudential Home Mortgage.