Can Momentum Investing Be Saved?
Related mainly to equity based momentum strategies:
Authors: Arnott, Kalesnik, Kose, Wu
Title: Can Momentum Investing Be Saved?
On paper, momentum is one of the most compelling factors: simulated portfolios based on momentum add remarkable value, in most time periods and in most asset classes, all over the world. So, our title may seem unduly provocative. However, live results for mutual funds that take on a momentum factor loading are surprisingly weak. No US-benchmarked mutual fund with “momentum” in its name has cumulatively outperformed its benchmark since inception, net of fees and expenses. Worse, because the standard momentum factor gave up so much ground in the last momentum crash of 2008–2009, it remains underwater in the United States, not only compared to its 2007 peak, but even relative to its 1999 performance peak. This means 18 years with no alpha, before subtracting trading costs and fees!
To be sure, most advocates of momentum investing will disavow the standard model, and will claim they use proprietary momentum strategies with better simulated, and perhaps better live, performance. A handful (especially in the hedge fund community) may be able to point to respectable fund performance, net of trading costs and fees. But a careful review of the competitive landscape reveals that most claims of the merits of momentum investing are not supported by data, particularly not live mutual fund results, net of trading costs and fees.
The three traps for momentum investing are 1) high turnover, in crowded trades, which leads to high trading costs; 2) a careless sell discipline, because momentum’s profits accrue for months, not years, and then reverse course; and 3) repeat winners (and losers), which have been soaring (or tumbling) for so very long they enjoy little or no momentum follow-through. Each of these traps can be avoided. By evading these traps, we can narrow the gap between paper and live results. Yes, momentum can probably be saved, even net of fees and trading costs.
This is the fourth and final article in the Alice in Factorland series.
Notable quotations from the academic research paper:
"One weakness of standard momentum strategies is that they do not distinguish between stocks as to whether they are early or late in their momentum cycles. We call the first group fresh momentum and the latter stale momentum. Stale momentum stocks are typically very expensive on the long side, and very cheap on the short side, with little likelihood of follow-through. Fresh momentum fares much better than stale momentum, especially since standard momentum went off the rails at the start of the current century. Investors will be better off if their strategies avoid stocks with stale momentum and instead rely more heavily on stocks with fresh momentum. If we’re going to incur trading costs to initiate momentum trades, we should perhaps concentrate those trades in the fresh momentum segment of the portfolio.
Another weakness of most momentum strategies is high turnover and high trading costs. Momentum funds use momentum to initiate momentum trades. Why don’t we turn this logic on its head? Why not use momentum to block (or at least condition) trades for other strategies, such as value, quality, low volatility, Fundamental Index, and so forth? Using momentum to block trades should improve performance on two levels. First, our strategy will be trading less, not more; after all, we incur no trading costs when we are deferring a trade. Second, the momentum effect — without trading costs — is one of the most robust in the literature, notwithstanding recent disappointments. If momentum — especially fresh momentum — improves the timing of our trades, we extract momentum alpha while reducing our trading costs, giving us the best of both worlds.
Momentum — at least as defined by the standard momentum factor — clearly does more harm than good on live assets in the mutual fund arena. It need not. It clearly needs saving. With a few simple steps, we think it can be saved, though not necessarily on a vast asset base."
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