Momentum Investing – Understanding The Risks by Jason Wang, ColumbiaManagement
- Momentum as a factor in investing decisions can be a valuable tool, but must be monitored carefully.
- Drawdowns can be severe if exposures are not structured mindfully.
- How momentum correlates with other market factors is crucial in considering its risks.
Actively seeking exposure to price momentum is a long-established tool in equity investing. However, momentum strategies have had a peculiar start this year. Performance has moved in lock-step with the inverse price of crude (Exhibit 1), which highlights the prevailing presence of unintended macro risk exposure in a momentum portfolio. This represents just another chapter in the long history of the vagaries of momentum investing. Investors seeking momentum in their portfolios should do so only when they are well-versed in the potential risks of such exposure.
Exhibit 1: Year-to-date price momentum strategy vs. crude oil price
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Source: Columbia Threadneedle Investments, 05/15
Notes: S&P 500 Index universe; price momentum is defined as 1-month lagged 11 months’ stock total return; top 20% – bottom 20%; monthly rebalancing; returns were weighted by the square root of market cap.
What is momentum investing?
Momentum strategies involve buying stocks that have performed relatively well and selling stocks that have performed relatively poorly. These types of strategies have been widely adopted, and a host of academic research has documented their profitability. For example, Jegadeesh and Titman (1993) finds that momentum strategies can generate significant positive returns over a 3- to 12-month horizon. Geczy and Samonov (2013) finds that the top third of stocks sorted on price momentum outperforms the bottom third by 0.4% per month over the long term. There are many reasons for the persistence of momentum effects including investor herding, under-and-over reaction and confirmation bias.
Risks associated with momentum investing
But momentum investing is not risk-free, and the internet bubble and the global financial crisis are sober reminders of the embedded risks (Exhibit 2). In both eras, momentum strategies experienced significant drawdowns and volatility. Therefore, investors need to look under the hood and have a thorough understanding of the sources of such risk.
Exhibit 2: Rolling 12-month spread highest momentum and lowest momentum
Source: Columbia Threadneedle Investments, 05/15
Notes: S&P 500 Index universe; price momentum is defined as 1-month lagged 11 months’ stock total return; top 20% – bottom 20%; monthly rebalancing; returns were weighted by the square root of market-cap.
In general, there are six types of risk associated with momentum investing:
- Stock specific risk
Just months before the eruption of the accounting scandal, Enron’s 2000 annual report touted the company’s 20 consecutive quarters of year-over-year growth. The company’s stock soared 256% over that same period and it looked extremely attractive based on momentum. Less than one year later, Enron’s shareholders lost all of their wealth.
- Valuation risk
Investors often chase certain “sexy” companies, pushing stock valuations sky high. At the peak of the internet mania, the NASDAQ Composite Index was valued at more than 100x forward earnings. The valuation multiples for names like Yahoo and Broadcom Corp. were fetching upwards of 300x. Investors invented their own performance metrics like “eyeballs” to justify those companies’ lofty price tags. Those high-flying stocks often become vulnerable to either earnings disappointments or sudden changes in the broad market environment. The NASDAQ index lost 70% of its value from March 2000 to February 2003.
- Sector risk
Momentum strategies that buy past winners and sell past losers inherently have sector bias. At the top of the dot-com bubble, information technology and telecommunications names accounted for more than half of the winner momentum portfolio based on prior performance. After the bubble burst, these two sectors reversed direction and became 60% of the loser portfolio. Consumer discretionary and financials went through similar loser-winner transition during and right after the global financial crisis. Exhibit 3 illustrates the sector concentration levels for the winner and loser portfolios over time.
Exhibit 3: Sector concentration levels for momentum winner portfolio and loser portfolio
Source: Columbia Threadneedle Investments; 05/15
Note: S&P 500 Index universe; MSCI GIC sector classification; the Herfindahl Index static is used to measure sector concentration.
- Macroeconomic risk
There have been periods when macroeconomic risks dominated the behavior of momentum strategies. In 2011 and 2012, there were constant risk-on/risk-off alternations driven by macro events such as U.S. government credit downgrades, the European sovereign debt crisis, the slowdown in emerging markets, and the political and military events in the Middle East. These uncertainties propelled oscillations in momentum strategies as well as volatility (Exhibit 4). Simply stated, the payoff to momentum is not immune to the macro environment.
Exhibit 4: Cumulative returns for price momentum vs. volatility
Source: Columbia Threadneedle Investments, 05/15
Notes: S&P 500 universe; price momentum is defined as 1-month lagged 11 months’ stock total return; volatility is a combination of long-term historical volatility and near-term historical volatility; top 20% – bottom 20%; monthly rebalancing; returns were weighted by the square root of market-cap.
- Market timing risk
Momentum investing assumes what was going up in the past will probably continue to go up in the near future, and vice versa. Hence, it generally works better in a smooth trending stock market. Likewise, momentum strategies struggle and often suffer huge losses during periods of high stock market volatility, especially at market inflection points, i.e., periods following recent bull market tops and bear market bottoms. Exhibit 5 clearly demonstrates that fact.
Exhibit 5: Ten worst monthly momentum returns over 1995-2015 period
Source: Columbia Threadneedle Investments
Notes: S&P 500 Universe; Price momentum is defined as 1-month lagged 11 months’ stock total return; Top 20% – Bottom 20%; Monthly Rebalancing; Returns were weighted by the square root of market-cap.
- Overcrowding and liquidity risk
Overcrowding, i.e., too much money investing in the same securities at the same time, has never been a good thing. Similar to shouting fire in a crowded theater, things can turn chaotic if everybody runs for the exit at same time. Yan (2013) argues that momentum crashes are, at least partially, due to crowded trades that push prices away from fundamentals eventually leading to strong reversals. One example would be the quant crisis. During the week of August 6, 2007, many popular quantitative strategies simultaneously experienced enormous negative returns. Khandani and Lo (2007) find that overcrowding and overleverage were the probable causes.
Risk control — Taming the shrew
In recent years, there has been a fair amount of research on how to improve momentum strategies from a risk-control standpoint. From this research and our own experience, we have found that the following techniques can help control the risk of momentum strategies and gain better risk-adjusted returns:
- Include valuation and quality into the bigger picture, and watch out for those high momentum stocks with expensive valuation and poor quality.
- Sector neutrality, namely comparing stocks with their industry peers, can help reduce unnecessary sector bets and macro bets like the movements of oil, interest rates, and currencies.
- Be mindful of a momentum laden portfolio’s exposure to beta, market volatility and aggregate level cross-sectional valuation spread. When systematic risk is severe, be cautious on momentum bets.
In summary, momentum can be a useful tool for investing. However, investors need to be cognizant of the risks inherent in their portfolios. Even investors not actively seeking exposure to momentum should be attuned to periods when momentum has already shown super-normal efficacy or is growing in association with unintended bets. These may be the times when momentum grows in correlation to volatility and seems to inevitably reverse violently, a situation best avoided.
Avramov, Doron, Si Cheng, and Allaudeen Hameed, 2015, Timing-Varying Liquidity and Momentum Profits, Journal of Financial and Quantitative Analysis, Forthcoming.
Barroso, Pedro and Pedro Santa-Clara, 2015, Momentum has its moments, Journal of Financial Economics.
Geczy, Christopher, and Mikhail Samonov, 2013. 212 Years of Price Momentum, Working Paper, University of Pennsylvania.
Heidari, Mahdi, 2015, Momentum Crash Management, Working paper, Stockholm School of Economics.
Jegadeesh, Narasimhan, and Sheridan Titman, 1993, Returns to Buying Winners and Selling Losers: Implications for Stock Market Efficiency, Journal of Finance.
Khandani, Amir E., and Andrew Lo, 2011, What Happened To the Quants in August 2007? Evidence from Factors and Transactions Data, Journal of Financial Markets.
Moskowitz, Tobias J. , and Mark Grinblatt, 1999, Do Industries Explain Momentum? Journal of Finance.
Rouwenhorst, K. Geert, 1998, International Momentum Strategies, Journal of Finance.
Yan, Philip, 2013, Crowded Trades, Short Covering, and Momentum Crashes, Working paper, Princeton University.