It sounds too good to be true – just buy stocks that are rising, and forget all that agonising over company balance sheets and earnings reports and so on. However, momentum investing may well be the most successful approach in stock market history, and there's little reason to think it will stop working any time soon.
That's according to high-profile hedge fund manager Cliff Asness, who has co-authored a paper* that takes aim at critics of this most basic of strategies.
While the outperformance of momentum strategies has been documented in academic papers for over 20 years, it’s easy to be snobby about an approach that resembles, as one commentator put it, a “lively game of hot potato”. Some see it as both dumb and reckless, and point to recent market reversals that have seen high-flying internet stocks like Twitter brought crashing back down to earth.
Momentum investing is not the same as trend following, however. Rather, it refers to the practice of selecting stocks that have outperformed on a relative basis.
Asness, who manages $105 billion at AQR Capital Management, points to 2008. Then, winners would be defined as stocks that might have recorded minor declines, in contrast to others that might have fallen by 30 per cent or more. During bull markets, he adds, losers would similarly be defined as stocks that were only up a few percentage points.
It works
And yes, it works. Between 1927 and 2013, the spread of recent winners over recent losers (as measured by returns over the previous 12 months, skipping the most recent month) averaged 8.3 percentage points annually. That's almost twice the 4.7 percentage points spread between cheap and expensive stocks, the approach that has long been celebrated by value investors. It is nearly three times as large as the annual premium enjoyed by small-cap stocks over large stocks.
Nor are the results distorted by a handful of big years – positive annual returns were recorded 81 per cent of the time, easily surpassing the figures for the value and small-cap strategies.
A fluke? No. The momentum effect can be found in 212 years of US data, says Asness, and dates back to the Victorian age in Britain. Definitively confirmed by academics in 1993, the momentum outperformance has persisted in 40 other countries and in more than a dozen other asset classes since then, he says, including in the bond and currency markets.
Myths
It's not the first time Asness has made the case for momentum – two decades ago, his work on the subject earned him a PhD from Nobel economist and efficient markets theorist Prof Eugene Fama, and he is prickly towards those who spread "myths" about the strategy. For example, some critics say momentum works for small stocks but not for large companies. That is true for value strategies but not for momentum, he says – the data confirms momentum is "almost equally as strong" among large stocks.
He’s similarly annoyed about claims that momentum is best left to short sellers betting against losing stocks. That approach works well, he says, but the long side of momentum investing is equally profitable.
Assertions that momentum investing is undermined by trading costs and tax considerations are also dismissed.
Of course, momentum investing does not work all of the time, and particularly big losses were seen in spring 2009, when markets abruptly reversed course and shot upwards. As criticisms, go, however, this is surely one of the weakest. No strategy works in all markets; some of the world’s best value investors, for example, saw their clients desert in droves in the late 1990s, when dotcom madness led to traditional valuation metrics being thrown out the window. Of course, the bubble eventually burst, and value strategies went on to outperform once again.
While value and momentum strategies tend to be viewed as polar opposites, Asness is a fan of both, and notes that utilising both approaches brings obvious diversification benefits. At cyclical extremes as in 1999 and 2009, he notes, maximum drawdowns are greatly reduced by combining the two approaches.
Disappear?
Of course, the momentum effect may disappear. Sceptics say this fear is credible because, while there may be a rationale as to why value and small-cap strategies have historically outperformed, there is no obvious theory as to why this should be the case for momentum. Unsurprisingly, Asness isn't buying this argument. Some strategies cease to work when they become widely known but there has been "no evidence of degradation" over the last 20 years, he says.
If anything, he understates the case on this point. As far back as 1937, academics noted that momentum had been a powerful determinant of annual returns over the 1920-35 period.
It's true that the theory remained under the radar in academic circles until the early 1990s, but this could not really be said of the investment community in general. Reminiscences of a Stock Operator, the classic book that details the momentum philosophy of legendary market speculator Jesse Livermore ("Prices are never too high to begin buying or too low to begin selling"), was published in 1923, and many age-old market adages reflect the tenets of momentum investing.
There are also many possible explanations for the momentum effect, especially from the behavioural school of investment, which suggests investors tend to both underreact and overreact to events. One can argue they are slow to fully price in new information, that they are too quick to sell their winners and too slow to sell their losers, thereby lengthening market trends.
It may also be that investors simply chase returns, says Asness, “providing a feedback mechanism that drives prices even higher”.
Whatever the reasons, the data shows momentum drives stocks, and has done for centuries, he says, adding: “We discovered the world wasn’t flat before we understood and agreed why”.
Squeamish
Clearly, the empirical argument for the momentum approach is a strong one, so why does it lack the intellectual credibility of, say, valuation-based strategies? It's likely that many are squeamish, for various reasons.
Financial Times columnist John Authers notes that momentum has nothing to do with the fundamentals, and says it "feels wrong that money can be made this way". Additionally, it is "without social merit" – whereas value investors help correct market mispricings by buying stocks when they get too cheap, momentum investors are "deliberately helping a market inefficiency grow even worse".
One might add that while institutional investors and hedge funds can profit from momentum by using a mechanistic momentum approach, ordinary investors are more likely to be parted from their money by both chasing expensive markets and bailing out just when hard-hit stocks are becoming cheap. The morals of value investing – think long term, don’t panic, see market declines as an opportunity rather than a curse – are altogether more salutary.
However, perhaps such agonising is ultimately irrelevant; the key point is, momentum works, and it's perilous to underestimate it.
*The paper, Fact, Fiction and Momentum Investing, can be read at http://goo.gl/YxQwOd.
