Academic Insights on Investing

What you need to know about momentum

The following article first appeared on CityWire RIA Magazine-February 2020.

It is the second of a series of four covering the most asked questions on #Momentum and summary results of research Tommi and I conducted on global factor investing.

Despite the cynicism, decades of evidence point to the momentum premium’s persistence, pervasiveness and survival of transaction costs.

Investors have been focused on the recent and prolonged underperformance of value, but what about momentum? Based on our research, it appears to have performed well across most countries and periods.

When we studied the performance of momentum across 10 developed markets between 1995 and now, we found that momentum outperformed in all but one – the exception being Japan.

Interestingly, Australia has been the clear winner for momentum, over both the entire historical period and shorter time periods, followed by Germany and Canada. Meanwhile, the US produced the lowest positive spread for momentum stocks, both over the entire history and over shorter time frames.

Can we time factors such as value and momentum?

We know that the return performance of value and momentum is typically negatively correlated, so it follows that having both factors in a single portfolio will reduce the risk of a downturn in one of the other factors. In 2013, Asness et al documented a negative correlation (an average of -0.6) between value and momentum factors in the different markets and asset classes that they tested.

We can confirm this result in the equity markets with slightly lower correlations. In any case, this is a powerful finding because it provides guidance to investors on how to build more robust portfolios with exposure to a diversified set of factors.

But what about the ability to time them? On this point, the academic jury is still out.

Some studies show that relative valuation does a good job of predicting the subsequent five-year performance of equity factors. Others counter that factor timing is difficult to achieve in practice. The methods used to evaluate the predictive power of relative valuation indicators don’t consider frictions such as portfolio turnover and changes in fundamentals.

There is some hope for factor timing though. The AQR research arm recently proposed that individual factors can indeed be successfully timed based on their own past performance.

We recommend factor timers read the article, ‘Factor momentum everywhere,’ published in the Journal of Portfolio Management in 2019.

The academic debate continues. Stay tuned!