Momentum can be an unintended friend or nemesis to your portfolio

PHILADELPHIA, PA, November 21, 2016 – FIS Group, a manager of U.S. and global developed, emerging and frontier markets equity portfolio strategies, today issued a Special Report that discusses the challenges and opportunities of momentum investing. The report, titled “Momentum: Beware of the Double-Edged Sword,” analyzes situations where momentum can be either a significant tailwind or exacerbate risks and undermine portfolio diversification.

“It’s key to cut through the noise and analyze the real driver for momentum in the market, sector, or stock rather than focusing on investor sentiment” says Tina Byles Williams, CEO and CIO of FIS Group. “Understanding momentum is just as critical as looking both ways before crossing a busy intersection for a pedestrian.”

The Special Report looks at historical data and focuses on three key points:

  • The significant return disparity during the past bull market, which stems from momentum
  • How investor sentiment, measured by Bear-Bull spread and relative strength, is a poor indicator for momentum
  • Momentum’s outsized impact in the last 16 months compared to other factors such as value

Momentum strategies may result in trade crowding, which occurs when multiple market participants with large pools of capital use similar investment strategies and trade in and out of similar positions. This reduces the future effectiveness of an investment strategy in predicting stock returns, and may also result in extreme levels of risk when investors experience negative shocks in other parts of their portfolios, forcing them to liquidate their positions. As more investors concentrate on the same factors, the degree of factor crowding increases; and at extreme levels, can result in “factor crashing” and significant performances drawdowns.

“We developed a factor crowding model to systematically discern factor crowding at the overall portfolio level,” says Byles Williams. “This is in addition to the analysis we do on our sub-managers’ investment processes and using our proprietary portfolio construction process to optimize fundamental factors, like momentum and value, within our strategies.”

In addition to Special Reports, Ms. Byles Williams contributes to FIS Group’s Market Insights Alerts, which are based on research that examines market conditions and Market Outlooks, which examine global economic themes and are published throughout the year. The last Market Insights Alert was published in November, 11 2016.


What Is Momentum Investing And Why Should Investors Be Aware Of It?

Momentum investing is traditionally defined as an investment strategy that seeks to capitalize on pricing trends. The idea behind the strategy is that established trends are likely to continue in the same price direction. The theoretical underpinnings for momentum investing is the intersection of technical and behavioral investing. Most investors define momentum as a positive or negative trend within a stock’s price movement over a defined period. It is sometimes associated with increasing trade volume within a stock, and is usually grouped among other technical indicators. As a behavioral indicator, it can be used to identify herding (crowding). Moreover, momentum investing can often lead to confirmation biases, which occur as investors use others’ actions to confirm that their own action is right (or wrong).

Understanding momentum is just as critical as looking both ways before crossing a busy intersection for a pedestrian. Blindly entering a market based solely on one view (whether it is right or wrong) without examining the whole landscape can have an adverse effect on portfolio returns and volatility. This is because momentum strategies may result in trade crowding, whereby a significant number of market participants with large pools of capital trade in and out of stock positions in order to pursue the same, or very similar, investment strategies. A crowded position occurs when there is a significant overlap of portfolio positions and allocations as a result of crowded trades which, in total, add up to a significant share of a stock’s free-float market capitalization. Crowding reduces the future effectiveness of a given investment strategy in predicting stock returns. Depending on the extent of the friction, such as shorting constraints and transactions costs, this overlap of positions among  managers may result in extreme levels of risk when those investors experience negative shocks in other parts of their portfolios, forcing them to liquidate their positions (selling what they can, rather than what they would necessarily like to). These “fire sales” may then cause losses for other investors following the same strategy and result in further liquidations, driving stock prices into a downward spiral. Crowding risk affects a wide range of so-called “unanchored” strategies, including momentum, that does not rely on a consistent or independent estimate of fundamental value. Investors tend to employ reasonable capacity assumptions in pursuing their own strategy, but they may underestimate the aggregate amount of capital following similar strategies. In this case, stock prices may over- or under-shoot their fundamental value and experience a sharp correction in subsequent periods as prices adjust to reflect fundamentals.

Crowding can also occur among market factors either as a result of highly correlated security selection or more directly, through correlated “smart beta” and/or factor-tilt strategies. As more investors concentrate on the same factors, the degree of factor crowding increases; and at extreme levels, can result in “factor crashing” and significant performances drawdowns. The “quant meltdown” which occurred during the 2007 through 2008 financial crisis is a classic example of crowded trades that led to certain factors and strategies, such as momentum investing, experiencing significant losses.

How Momentum Investing Created A Disparity Of Returns Over The Past Few Years

Viewed over a long-term perspective, most performance research indicates that the primary contributors to returns based on the research done by MSCI Barra were momentum and value. CHART 1, provided below, is a study conducted by MSCI Research on performance from December 1996 through December 2013, which substantiates this commonly agreed upon conclusion.

Momentum Investing

This chart echoes the thoughts of some practitioners who posit that only value or momentum factors exhibit a sustainable performance advantage.

Over the trailing six years through 9/30/2015, momentum, as defined by relative price strength, provided a significant tailwind to investment portfolios. As shown below, the top two quintiles of relative strength outperformed the growth indexes significantly, while the median and bottom quintiles underperformed US equity markets (as shown below). The only place where this was not evident is in the Midcap benchmark, where the median quintile outperformed the index. (See TABLE 1).

Momentum Investing

We used the growth indices because momentum investing is more often incorporated within growth strategies than value based strategies. Also, within the time period examined, growth indices were heavily influenced by the unprecedented run-up of the health care sector that was fueled by the biotech industry. Before 2015, health care outpaced the other 10 sectors over each of the past five years. During this timeframe, as FTSE and Russell did their annual index rebalancing, the biotech industry weighting crept up as a by-product of their outperformance. The biggest effect was in the smaller market cap indexes (Russell 2000 Growth and Microcap Growth), where biotech is one of the most significant industries within the index.

Investor Sentiment As A Proxy For Momentum

Many managers that we have evaluated over the years consider investor sentiment to be a partial proxy for momentum. We evaluate this

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