Momentum investing is a lot like surfing, according to Research Affiliates’ Chris Brightman and Engin Kose. Both involve trying to “catch a wave” – and both can be very dangerous. Momentum trends can persist over significant periods of time but then reverse abruptly and with little warning. These periodic crashes can leave all but the most skillful managers in the red, and they also make momentum-based index strategies difficult to implement.
One way to address these challenges is to combine momentum investing with its inversely correlated cousin, value investing. According to Research Affiliates, the combination can exploit the advantages of both styles while simultaneously improving a portfolio’s risk-adjusted returns. The firm expresses this view in the September 2015 white paper “How NOT to Wipe Out with Momentum,” written by Brightman and Kose.
Navigating Dangerous Currents
Since at least 1987, momentum investing has consistently generated alpha across markets, with the notable exception of Japan. Data for the U.S. going back to 1967 show the strategy has been a consistent winner domestically since at least that far back.
But implementing momentum strategies is particularly difficult during times of enhanced market stress, such as the dot-com bust of 2000 and the financial crisis of 2008, which saw U.S. equity-market drawdowns of 31% and 57%, respectively. Momentum investors who rebalanced quarterly, for instance, would have been out-of-position for the market’s sharp move down, and they may have encountered liquidity crunches as they attempted to exit crowded trades; and even momentum investors who successfully rode those waves lower may have found themselves caught in the undertow when markets started to rebound.
Combining Value and Momentum
Value investing often goes against momentum. This is because value stocks are often “out of favor,” which is why they’ve become attractive to value-oriented investors. Thus, it’s not surprising that value and momentum are often inversely correlated – and by combining the two styles, the severe drawdown risk described in the preceding paragraph can be mitigated.
Dating back to November 1990, momentum strategies have generated an average annualized return of 6.79%, while value has averaged 4.02%. Not surprisingly, momentum strategies have been more volatile, averaging annual volatility of 16.42%, compared to value’s 12.25%. The Sharpe ratios for the two strategies, which measures risk-adjusted return, were 0.41 for momentum and 0.33 for value. But – because momentum and value are inversely correlated – a combination of the two strategies boosts their combined Sharpe ratio to 0.78. Thus, the power of diversification.
Avoiding the Next Crash
In Research Affiliates’ view, standalone momentum strategies – whether passive or active – perennially face the potential of being wiped out and erasing any value they’ve brought to the table up to that point. While standalone momentum can make sense for particularly astute and hardworking active managers, RA prefers an approach combining momentum and value for most investors. In author’s surfing metaphor, this combination “can open a performance pipeline for the investor who can make a clean escape as the wave closes behind him, crashing on the investors who are not exploiting momentum’s insights in a similar way.”