The prolific team at Alpha Architect are out with a new book called Quantitative Momentum: A Practitioner’s Guide to Building a Momentum-Based Stock Selection System. It is a wonderful book for anyone wanting to understand how to implement momentum-based strategies into his or her portfolio, or even just for those who simply want to understand better the concept of momentum investing.
Given that momentum investing has become more familiar even to casual investors, I asked our friends at Alpha Architect if they would take some time to answer some questions on momentum strategies. Here below are their explanations:
LH: In simplest terms, what is momentum, and how do you quantify or qualify it?
Alpha Architect: A momentum investing strategy involves investing in securities that have had the best performance over the past year. Here is a simple simulation study we have completed to show the performance from 1963 – 2013.
Momentum is measured as the total return of a security over a certain time period.
Here is a simple example. Stock A (which does not pay a dividend) was worth $10.00 a year ago, and is worth $15.00 today while stock B (which also does not pay a dividend) was worth $10.00 a year ago, and is worth $5.00 today. Measuring their momentum (or total return) over the past year, stock A is up 50% and stock B is down 50%. If we only had a two stock universe (stock A and stock B), a momentum strategy would have an investor buy stock A as it was the best performing security over the past year.
An improvement to a simple momentum calculation would be to exclude the previous month return from the “momentum” calculation (as this mean reverts). Chapter 5 of our book, Quantitative Momentum, discusses basic momentum calculations in detail.
LH: How is it different from trend?
Alpha Architect: Momentum has two implementations for trading / investing strategies. Here are the two ways to measure and use “momentum.”
- Cross-sectional momentum: Originally referred to as “relative strength,” before academics developed a more jargon-like term, cross-sectional momentum is a measure of an stock’s performance, relative to other stocks. In the example above, we compare stock A to stock B, and invest in stock A since it had a higher performance relative to stock B.
- Time-Series Momentum: Sometimes referred to as “absolute momentum” or “trend,” time-series momentum is calculated based on a stock’s own past return, considered independently from the returns of other stocks. In the example above, we examine the total returns to stock A to stock B, and invest in stock A since its total return is above 0%, while we do no invest in stock B as its total return is below 0%. In this context, “trend” means to invest in a security / asset if the returns over the past year are positive (or above some base rate, such as the risk-free rate).
Investors can use one of the momentum signals, or even both of the signals. Our book mainly discusses the first type of momentum, “cross-sectional momentum.”
LH: A lot of people confuse momentum and growth, are they the same?
Alpha Architect: Momentum investing involves buying stocks that have had high returns over the past year, while growth investing involves buying stocks which have a high price relative to some accounting number, such as earnings, hence the Price-to-Earnings (P/E) ratio. The definitions sound similar, but they are definitely not the same! Examining the returns, a simple momentum strategy has produced annualized average returns above the market since 1927 (not every year however), while a growth investing strategy has produced annualized average returns below the market since 1927 (not every year however). So long-term investing in growth stocks was a bad bet! However, since the two measures sound the same, what is the overlap of the portfolios? We find that from 1963-2014, the overlap is around 29%. Meaning that 71% of the high momentum stocks are not considered growth stocks.
Big picture – momentum investing is not the same as growth investing!
LH: In your opinion, is a momentum strategy a core or a satellite strategy for a portfolio? Does it make sense for most investors to employ?
Alpha Architect: We believe it can be used as both.
However, it is important for investors and advisors to understand the portfolios, and how they will behave relative to a benchmark. Here are the historical returns to momentum portfolios if one varies (1) the number of stocks and (2) the holding period for each stock – clearly the takeaway is that investing in (1) a more highly concentrated portfolio that is (2) rebalanced more often was a better bet in the past (before fees). For our momentum portfolios, we build highly concentrated portfolios that are rebalanced every quarter. However, the higher the concentration, the higher the tracking error relative to an index – what this means is that as an advisor or investor, going “all in” on a momentum portfolio (or any other factor) can from time to time cause massive underperformance relative to an index (as well as outperformance other times).
For more highly concentrated portfolios, we generally recommend using highly concentrated portfolios as satellite positions to a portfolio (5-10%), unless the investor truly understands the tracking error, and can live with relative underperformance.
LH: What is the simplest (or most efficient) way for ordinary investors to utilize momentum strategies?
Alpha Architect: For most investors, the easiest way is to invest in a momentum ETF or mutual fund. We prefer the ETF wrapper due to higher tax efficiency. When assessing different momentum ETFs, it is important to examine the fees as well as the portfolio construction.
 The favorite academic measure is the Book-to-Market (B/M) ratio.
The information provided above is obtained from publicly available sources and it is believed to be reliable. However, no representation or warranty is made as to its accuracy or completeness.
This article originally posted on http://www.fortunefinancialadvisors.com