This blog is an adjunct to our Optimal Momentum investing website which can be found through the Website tab. It contains news and other information that may be of interest to momentum investors.

Wednesday, June 4, 2014

"Fact, Fiction, and Momentum Investing"

The AQR posse (Asness, Frazzini, Israel, and Moskowitz) recently issued a working paper that disproves many often-repeated myths about momentum investing, particularly as it applies to individual stocks. The authors back up their reasoning with results from academic papers and publicly available data. Here are the myths they address: 
  •   The momentum anomaly is small and sporadic 
  • ·It works mostly on the short side
  •   It works well only among small stocks
  •   It does not survive trading costs
  •   It does not work for a taxable investor
  •   It is best used as a screen rather than as a regular investment factor
  •   Its returns may not persist
  •   It is too volatile to rely on
  •   Different measures of momentum may give different results
  •   There is no theory or reasonable explanation to support it
 Below is a quick summary of the authors' evidence-based counter arguments:

1)  There is overwhelming evidence from scores of studies showing that momentum returns are remarkably stable and robust.

2)  There is little difference in performance between the long and short sides of momentum based on factor model regressions. Based on average returns versus the market, the long side has contributed more to momentum profits.

3)  As for working only among small caps, this is true only if you replace the word "momentum" with the word "value". Two of the authors, Israel & Moskowitz, wrote an important paper last year called "The Role of Shorting, Firm Size, and Time on Market Anomalies" that clearly showed this. That paper was the subject of my post, "Momentum...the Only Practical Anomaly?" Momentum actually works well across all size stocks and is more robust among large stocks.

4)  A study last year by three of these authors called "Trading Costs of Asset Pricing Anomalies" looked at large institutional trades across nineteen developed markets from 1998-2013. They found the trading costs of momentum to be low, despite a higher turnover than from other factors.

5) Several studies show that even though momentum with individual stocks has 5-6 times the annual turnover of value strategies, momentum actually has a similar tax burden. This is because momentum holds on to winners and sells losers, which avoids short-term gains in favor of long-term ones. Momentum also has a much lower dividend exposure than value.

6)   The authors point to papers showing that momentum works better as a factor-based approach than as a screen-based one.

7)  As for momentum's returns disappearing, one can say the same of any anomaly. Abnormal momentum returns have survived, however, for the past 212 years. Momentum has held up to considerable out-of-sample validation across time, geography, and asset type. The authors point out, "There is no evidence that momentum has weakened since it has become well-known and once many institutional investors embraced it and trading costs declined."

       8) Relative strength momentum is volatile, but the Sharpe ratio (which includes volatility) of momentum still comes up on top. The authors say, "Who are you calling small and sporadic?" (The authors ignore absolute momentum, which significantly reduces expected volatility and drawdown.)

9)  The authors agree that different measures of momentum can give different results, but they point out that this is true of any strategy. Different measures of momentum giving good results is a sign of robustness and not a cause for concern.

10) Momentum can be explained by either risk based or behavioral factors. As long as risks, risk preferences, biases, and/or behaviors do not change, momentum profits should continue unabated as they have for the past 200+ years. (My forthcoming book shows how behavioral biases are part of our DNA and are unlikely to change.)

The authors point out that most of the above myths can be shattered by a quick visit to Kenneth French's data library website. It is refreshing to see the authors, brought up in the Chicago efficient markets tradition, take on the challenge of those who say momentum profits cannot persist (despite plenty of evidence to the contrary) because that would contradict the theory of efficient markets. The authors point out that rejecting data because of a theory (or a one-sided view of the world) can be dangerous. They point to Columbus, Galileo, and the Salem witch trials as examples. Bravo!

The only problem I have with their paper is that the authors, perhaps keenly aware that risk-adjusted  momentum profits from individual stocks have been uninspiring over the past thirty years, repeatedly point out  that momentum works best when it is combined with value. Yet we can easily see in the aforementioned Israel & Moskowitz study that commonly used measures of value hold up only among the smallest stocks, and these are impractical for many investors to hold. Maybe the AQR crew needs to take a closer look at the true value of the emperor's new clothes.

Monday, May 19, 2014

Book Musings

Now that I have turned my book manuscript into my publisher, I can get back to doing some blog posts. My book's title is Dual Momentum Investing: An Innovative Strategy for Higher Returns with Lower Risk. McGraw-Hill will release it in November.

Putting together the book was an interesting project. Wes Gray, of Alpha Architect, kindly provided me with a sample book proposal, and I put a lot of effort into organizing my thoughts. It paid off in that all three publishers I approached offered me a book contract. 

I did not want to limit the book's scope to just momentum, although there certainly is a need for a comprehensive book that explains the salient points of momentum investing. This marks the 40th year since I began my investment career, and I wanted to incorporate other information that I thought might be helpful to investors. The book took on a life of its own soon after I got started. Thanks to the internet, I was able to go deeper into some topics than I had thought possible. In the words of Roger Ebert, "The muse visits during the act of creation rather than before." Here is a list of chapter titles: 

 DUAL MOMENTUM INVESTING

Chapter 1              World's First Index Fund                         
Chapter 2              What Goes Up…Stays Up                           
Chapter 3              Modern Portfolio Theory Principles and Practices                           
Chapter 4              Rational and Not So Rational Explanations of Momentum
Chapter 5              Asset Selection: the Good, the Bad, and the Ugly 
Chapter 6              Smart Beta and Other Urban Legends
Chapter 7              Measuring and Managing Risk
Chapter 8              Global Equities Momentum 
Chapter 9              Mo' Better Momentum 
Chapter 10            Final Thoughts 

Sunday, January 12, 2014

Introducing Global Equities Momentum

I feature Global Equities Momentum (GEM) in my forthcoming book, so it is time to introduce it on our website. GEM is a simple but powerful model that switches between the S&P 500 Index, the MSCI All Country World Index ex-US, and the Barclays Capital US Aggregate Bond Index based on dual momentum. GEM is long just equities as long as their trend is positive based on absolute momentum. When the trend of stocks is down, GEM is only in bonds. My book will fully explore the characteristics of this model.

The long run risk premium (and expected return) of bonds is substantially lower than the risk premium of stocks, so stocks are the investment vehicle of choice as long as their trend is positive. There are, however, investors who, for fiduciary or other reasons, need to keep a permanent allocation to bonds. For this reason, we also track our model that maintains 60% in stocks and 40% in bonds. We call this Global Balanced Momentum (GBM). (Formally, we called it the Global Balanced Momentum Index.) GBM applies dual momentum to both stocks and bonds.

Finally, we continue to show the performance of dual momentum applied to US equity sectors. We call this Dual Momentum Sector Rotation (DMSR).  Please check out all three of these models that are now on the Performance Page of our website.

Past performance is no assurance of future returns. Please see our Disclaimer page for other disclosures.

Friday, October 18, 2013

Momentum Hierarchy

The chart below shows how dual momentum, absolute momentum, and relative momentum stack up against one another with our Dual Momentum Sector Rotation model. (No allowance has been made for transaction or other costs.) The light brown line at the bottom of the chart is the S&P500. The dark brown line just above it is an equally weighted average of all the sectors we use. Its shape is similar to the S&P 500, which means that volatility and drawdown are similar to the market's volatility and drawdown. Equal weighting shows modestly higher returns, due to mean reversion profits from monthly re-balancing and equal, rather than capitalization, weighting across sectors.

 Past performance is no assurance of future success. Please see our Disclaimer page.

The purple line shows relative strength momentum. It has higher profits than equal weighting, but retains the performance characteristics of the S&P500. Relative strength momentum typically boosts returns, but does little to reduce volatility or drawdown. It is the best known and most commonly used form of momentum investing.

When we get to the green line representing absolute momentum, things change. Returns are better than with relative momentum. More importantly, the dips representing larger drawdowns flatten out or disappear. Absolute momentum was out of stocks during all of the 2001-02 and most of the 2008-09 bear markets.

In the hierarchy of investment returns, equal weighting with re-balancing beats the S&P500. Relative strength momentum beats equal weighting. Absolute momentum not only beats relative strength momentum, but it is more stable and consistent. If you have to choose just one approach, then absolute momentum looks best. 

However, we are not limited to just one approach. The blue line shows what happens when you combine relative and absolute momentum. Returns improve further while retaining absolute momentum's more attractive risk profile. Dual momentum is where you really want to be.

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