There is strong evidence that momentum investing works, even though some critics claim that a stock’s past performance can’t be relied on to predict its future returns, and that momentum strategies can involve high turnover and the risk of a trend reversing.
We spoke to Willem Jellema, the dedicated momentum portfolio manager in Robeco’s Quantitative Equities team, to find out more about Momentum and how Robeco exploits this proven factor premium while avoiding the potential pitfalls it can involve.
“Back in the 17th century, Isaac Newton showed that bodies that are moving tend to remain in motion. This law of nature has also been shown to hold true in financial markets today: stocks that have done well generally continue to do better on average, and the reverse is true for stocks that have performed poorly.”
“An important reason is that it’s hard to successfully implement a momentum strategy in practice. It can expose investors to the reversal risk after periods of momentum driven by overreaction. Transaction costs can also pose a problem, as momentum can be a high-turnover strategy.”
“We believe that Momentum is one of the most attractive factor premia in existence, and that it should form part of every successful factor equity strategy. To optimally harvest the momentum premium, Robeco Momentum Equities takes an active approach to negate the pitfalls of reversal risk and transaction costs linked to traditional momentum strategies.”
“Our active approach reduces exposure to style factor risk, such as exposure to the market. Contrary to what proponents of a risk-based explanation for momentum believe, in our view this risk is unrewarded. Furthermore, our portfolio construction process brings down transaction costs to acceptable levels: our realized turnover is lower than that of the MSCI Momentum index. Finally, our momentum strategy doesn’t go against other proven factor premia: for example, we prefer cheaper momentum stocks to more expensive ones to avoid going against the value effect.”
‘Our momentum strategy doesn’t go against other proven factor premia’
“We reduce the unrewarded exposure to style factor risk with our internally developed residualization technique. What does this mean exactly? In short, we select stocks that have performed well due to their individual stock-specific characteristics rather than those that have risen because they are highly geared towards a strongly performing market.
We do this by correcting stock returns for their exposure to style factors such as market beta. Our residualization technique removes the risk linked to reversals in style factors. This enables us to primarily select stocks that have good momentum because of investor under-reaction, which is a much more stable driver of returns than the riskier over-reaction.”
“Whenever we rebalance a momentum portfolio, we select the stocks that score best according to our freshly updated momentum model, which applies our residualization technique to the momentum signal and penalizes stocks that score badly on other proven factors (such as Value and Low Volatility).
We only invest in a stock if the added exposure to the momentum premium it provides outweighs the costs of buying it and selling a less attractive stock. This is how we achieve much lower transaction costs than other momentum strategies. The whole process is highly structured, automated and based on transparent rules, so despite the different steps involved, it is simple to implement and we understand exactly what’s going on in the portfolio. So it’s not a black box, and in this way we stay in control.”
“Momentum is a great diversifier in a factor premium equity portfolio because of its low correlation with other factors like Low Volatility, and in fact it can even have a negative correlation with Value. By not going against other factors when we construct our portfolio we achieve a correlation close to zero, so we do not lose money by, for example, being exposed to growth stocks as a result of taking exposure to Momentum.”
“We’ve been researching and implementing Momentum ever since we started building stock selection models in the 1990s, and our first fully quant equity portfolio in 2002 profited from the momentum effect. Based on this long experience we launched our unique active momentum strategy in 2012, and we will continue to improve the way we exploit the Momentum factor.”
“Most clients of our momentum strategy invest in it as part of a broader factor equity strategy, but with our strong three-year track record we are seeing more and more interest in stand-alone allocations to the strategy. Last year’s positive momentum premium and the excellent performance of our strategy again showed the importance of Momentum and how we can harvest it with our active approach, so we expect our strategy to keep gaining its own momentum.”