On momentum and factor investing
Factor investing
Factor investing is an investment approach that involves targeting quantifiable firm characteristics or “factors” that can explain differences in stock returns. Characteristics that may be included in a factor-based approach include
The most famous factors are size and value from the Fama–French three-factor model.
A factor-based investment strategy involves tilting investment portfolios towards and away from specific factors to generate long-term investment returns in excess of benchmarks. The approach is quantitative and based on observable data, such as stock prices and financial information, rather than on opinion or speculation.[4][5]
Momentum as a factor
In capital market theory, the momentum factor is one of the most well-known market anomalies. In studies, it has been observed that securities that have risen in recent months tend to continue to rise for a few more months. Likewise, assets that have declined in recent months tend to continue to decline for a few more months.
The invention of momentum
In 1993, Sheridan Titman and Narasimhan Jegadeesh showed that there was a premium for investing in high momentum stocks.[13] The authors reported abnormal returns in the extreme decile portfolios of 2.5% per month, using a very long time period 1934–1987. Notice that 2.5% per month is 30% annualized, which is a hefty return. This finding has been confirmed by many other academic studies, some even going back to the 19th century [11][12].
Momentum history
Did Jegadeesh et al invent momentum investing when they published their paper? Maybe not. Researchers have identified persistent momentum trends in stock markets as far back as the Victorian Era (ca. 1830s to 1900).[5] Richard Driehaus (1942–2021) is sometimes considered the father of momentum investing but the strategy can be traced back before Donchian.[6] The momentum strategy takes exception with the old stock market adage of buying low and selling high — according to Driehaus, “far more money is made buying high and selling at even higher prices.”[7]
Explanation of outperformance under the Efficient Market Hypothesis
While momentum investing is well-established as a phenomenon no consensus exists about the explanation for this strategy, and economists have trouble reconciling momentum with the efficient market hypothesis.
Seasonal or calendar effects may help to explain some of the reason for success in the momentum investing strategy. If a stock has performed poorly for months leading up to the end of the year, investors may decide to sell their holdings for tax purposes. Once the reason for tax selling is eliminated, the stock’s price tends to recover.
Two main hypotheses have been submitted to explain the momentum effect in terms of an efficient market.
- In the first, it is assumed that momentum investors bear a significant risk for assuming this strategy, and, therefore, the high returns are compensating for that risk.[3]
- The second theory assumes that momentum investors exploit behavioral shortcomings in other investors, such as investor herding, over- and underreaction, and confirmation bias.
Drawbacks: turnover and crashes
There are two major problems in the performance of momentum: turnover and crashes.
Turnover tends to be high for momentum strategies, which could reduce the net returns of a momentum strategy. Some even claim that transaction costs wipe out momentum profits.[13] This could be mitigated by selecting assets with sufficient size and liquidity, which of course might come with a drawback of reduced alpha due to a restricted asset universe.
The performance of momentum comes with occasional large crashes, requiring the investor to stomach drawdowns. In the paper “Momentum Trading, Return Chasing, and Predictable Crashes” the authors find 1% or 0.5% alpha per month, although with severe crashes. Crashes were more likely when momentum had recently performed well.
“Even the large returns of momentum do not compensate an investor with reasonable risk aversion for these sudden crashes that take decades to recover from”, Barosso and Santa-Clarain wrote an article with a catchy titled Momentum has its moments. “Compared with the market, value, or size factors, momentum has offered investors the highest Sharpe ratio. However, momentum has also had the worst crashes, making the strategy unappealing to investors who dislike negative skewness and kurtosis.”
Risk-managed momentum
To alleviate the problems with momentum crashes, Barosso and Santa-Clara proposed a way to manage the downside risk:
“We simply scale the long-short portfolio by its realised volatility in the previous six months, targeting a strategy with constant volatility.” It worked out for them: the maximum drawdown went from -96% to -45%.
Momentum exchange-traded funds
Exchange-traded funds with momentum began trading in 2015.[9] The largest one is the iShares MSCI USA Momentum Factor ETF with $13 billion in assets under management. It has outperformed S&P500 the last 5 years but underperformed the last year. This ETF tracks an MSCI momentum index described in another medium post.
Sources
Lastly, a note on how I wrote this blog post. My description of the MSCI Momentum index is a rewrite of their index methodology. For the rest of the article, I have cut and pasted freely from https://en.wikipedia.org/wiki/Factor_investing and https://en.wikipedia.org/wiki/Momentum_investing as well as the footnotes they describe. Some sentences are kept as-is and some are edited, since Wikipedia allows copying and pasting I found no reason to write quotations around non-edited sentences. In the few cases where I have copy-pasted from a scientific article, I have used quotation marks and made sure to provide a link to the article so give credit where credit is due.
