Swedroe: The Mystery Of Momentum

Momentum is large, persistent and—most of all—mysterious.

Momentum is a well-established, empirical fact. Its premium is evident in more than 87 years of domestic market data, in more than 20 years of out-of-sample evidence beginning from the time of its original discovery, in statistics from 40 other countries, and in the performance of more than a dozen different asset classes.

In fact, the momentum premium has been both larger and more persistent in the U.S. since 1927 than the other three stock premiums—equity, size and value. Over the last 87 calendar years (1927-2013), the annual momentum premium was 8.4 percent. It was positive in 78 percent of the years during that period.

By comparison, the figures for the equity, size and value premiums are not quite as strong or persistent. Over the same time frame, the equity premium was 8.2 percent, and it was positive in 68 percent of those years; the size premium was 3.1 percent, and it was positive in 56 percent of those years; and the value premium was 4.9 percent, while showing a positive return in 62 percent of those years.

While no one questions that the source of the equity premium is in taking greater risk with stocks, there is much debate in the academic community about the source of the other three premiums—especially value and momentum. There are numerous papers providing both behavioral and risk-based explanations for the value premium. For example, the risk side explanations include:

• Value stocks have more leverage, both financial and operating
• Value stocks have higher volatility of earnings and dividends
• Higher returns to value stocks are systematically related to business cycle fluctuations as indicated by the macroeconomic variables of default and term spreads
• Value companies have more irreversible capital
• Value companies have more uncertain cash flows
• Value companies are more subject to risk during monetary policy contractions, or periods associated with increasing risk of labor capital

On the other hand, behavioralists believe the value premium results from pricing mistakes. These occur when investors persistently overprice growth stocks (especially small growth stocks) and underprice value stocks. There are many academic papers that favor this view.

Explanations include the presence in the market of investors that tend to confuse the more familiar growth companies with safe companies and investors who prefer investments with lotterylike distributions; in other words, investors who are hoping to find the next Google. These investors opt for the small chance of winning a large sum, and they underestimate how quickly abnormal earnings (either faster or slower than average) revert to the mean.

When it comes to momentum, there are a few papers advocating a risk-based account, but most of the literature favors a behavioral explanation, either because of under- or overreaction. As Tobias Moskowitz points out in his paper, “Explanations for the Momentum Premium,” investor “under-reaction results from information travelling slowly into prices. That causes momentum.

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.