Momentum investing: the next game changer?
Investors are increasingly allocating strategically to factor premiums. But momentum has—so far—missed the party, thanks to its associated challenges. Willem Jellema looks at new ways to capture the momentum premium while eliminating the drawbacks.
Q: What is the momentum effect?
A: It is the tendency of stocks to have persistence in performance. So stocks that performed well in the recent past tend to outperform other stocks in the subsequent period. Similarly, stocks with poor returns also tend to lag in the following period.
Q: Why does the momentum effect exist?
A: Academics have put forward a number of different explanations. But we believe the momentum effect is an anomaly that is explained by the behavior—specifically under-reaction—of market participants.
Two causes of under-reaction are the disposition effect—the tendency for investors to sell shares whose price has risen but to keep hold of assets whose value has fallen—and anchoring—the bias to rely too heavily on old information.
As an example of anchoring, take Steve Jobs’ return to Apple. When the company started to make successful products such as the iPod, the share price did move up initially, but it only started to properly reflect the company’s improved circumstances after a considerable period. This is partly explained by investors’ under-reaction to the change in the company’s fortunes: they remembered Apple’s difficulties under Jobs’ previous leadership and when he was absent from the company.
Q: How does momentum fit into a portfolio that allocates to factor premiums?
A: There are two main reasons why a momentum fund can greatly benefit such a portfolio. First, momentum has a high factor premium. Indeed, research on the US shows that momentum has the highest return of all the factor premiums, even higher than value. As such, it can be an important source of return for a factor portfolio.
The second strong plus-point is diversification. The momentum premium has a low correlation with the low-volatility premium and a negative one with the value premium.
Q: Given those benefits, momentum strategies must be popular?
A: Not at all. Despite the attractions, very few funds attempt a systematic harvest of the momentum premium. As result, many investors have a negative exposure to momentum. That is a risk, especially when momentum performance picks up again.
Q: Why isn’t momentum more popular?
A: Momentum isn’t a free lunch. We see two main issues with conventional momentum strategies: high risk and large transaction costs.
Consider the scenario of a reversal after a bull-market rally. The high-beta stocks that do well in an upward-trending market—and which would be the main holdings of a generic momentum strategy—would be the biggest losers. The risk thus comes from losses on high-beta stocks. Meanwhile, hefty transaction costs result from a shift to low-beta stocks—the new winners—and having to sell struggling stocks in a down market. A successful momentum strategy has to be able to harvest the momentum premium while controlling these accompanying risks.
“A successful momentum strategy will harvest the momentum premium while eliminating the accompanying risks.”
Q: How do you deal with the risks associated with momentum strategies?
A: Rather than selecting stocks based on their past total returns, our technique involves selecting stocks based on their stock-specific returns, which are unrelated to the market or other style factors. We do this because our research shows that the extra risks from these style tilts are unrewarded. The result is a similar return pattern as a generic momentum strategy, but at much lower risk.
Q: How can you reduce transaction costs?
A: We believe that using smart trading-rules in investment strategies results in a much lower turnover compared with naïve trading algorithms. They also ensure that the negative impact of trading costs on gross performance is minimized. We apply the proprietary portfolio construction process that is used by all our quant equity products. It uses a sell-driven algorithm that takes into account liquidity and keeps transactions to a minimum.
Q: What distinguishes Robeco Momentum Equities?
A: Robeco Momentum Equities has been structured to harvest the momentum premium in an efficient way by avoiding unrewarded risks and limiting transaction costs. As chart 1 shows, it aims to capture more of the gross momentum premium at lower risk.
Chart 1: The Robeco Momentum Equities concept
Q: What are your expectations for momentum strategies?
A: Because of the growth of interest in factor investing and the implicit underweight in momentum of many portfolios, we believe that momentum will become increasingly important in the allocation process. We will continue to provide investors with solutions in this area.
Willem Jellema is the portfolio manager of Robeco Momentum Equities