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Momentum: The 4th Factor?

July 31, 2012 - 0 comments

Forget everything you’ve read about “past performance not predicting future performance”. Momentum investing is a well-documented phenomenon, in which winning stocks continue to be winners, and losing stocks remain losers (at least in the very short term). The very existence of momentum appears to challenge the Efficient Market Hypothesis (EMH), which asserts that stock prices instantly change to reflect new information.

 
Construction of a Momentum Index
The construction of a momentum index is surprisingly straightforward and transparent.  I have included the methodology for momentum indices constructed by AQR Capital Management below:
  • Rank the stocks in the investment universe by their total return over the prior twelve months (excluding the last month)
  • The top 33% of stocks with the highest rank are included, and weighted based on their market capitalization
  • The index is reconstituted quarterly
Momentum as a Complement to Value
In a 2009 white paper published by AQR Capital Management, they studied the annual excess returns (relative to the Russell 1000 Index) from the AQR US Large Cap Momentum Index and found them to be negatively correlated to excess returns from the Russell 1000 Value Index. This would imply that one could increase the diversification of a portfolio by combining the two strategies.
 
Tracking Error Relative to the Market
Momentum and value strategies have both experienced prolonged periods of underperformance relative to the market. This tracking error may cause investors to lose faith and abandon their original plan. A balanced portfolio combining these two factors has historically resulted in lower tracking error relative to a balanced market portfolio.  
 
In Table 1 below, I’ve created four balanced portfolios: Market, Momentum, Value, and Value + Momentum.  In Table 2, I’ve illustrated the historical 3-year rolling tracking error relative to the Market portfolio for each of the remaining three portfolios. As we can see, the tracking error is reduced significantly by combining Value + Momentum in a portfolio (dark blue line).
 

Sources:  AQR Capital Management, Dimensional Returns 2.0

 

Sources:  AQR Capital Management, Dimensional Returns 2.0

 
Risk-adjusted Returns
Although the Momentum and Value portfolios had higher risk-adjusted returns (i.e. Sharpe Ratio) than the Market portfolio, combining Value + Momentum in a portfolio actually increased the risk-adjusted returns further.  
 

Sources:  AQR Capital Management, Dimensional Returns 2.0

 
Transaction Costs
AQR Capital Management estimates the transaction costs of their large cap U.S. momentum strategies to be around 0.70% annually. This would decrease some of the benefit associated with implementing a momentum strategy in a portfolio.
 
Turnover
AQR Capital Management estimates the annual turnover of their large cap U.S. momentum strategies to be in excess of 100%. For taxable investors, the constant buying and selling of stocks may result in additional realized capital gains. To counter this potential drawback, they have recently introduced “tax-managed” momentum funds.
 
Conclusion
Incorporating momentum into a portfolio appears to have significant diversification benefits for investors. As more low-cost and tax-efficient momentum products are released, adding momentum stocks to a portfolio may become as common as adding small cap and value stocks.

 

By: Justin Bender with 0 comments.
Filed under: Factor Investing
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