Momentum: Beware Of The Double-Edged Sword – FIS Group

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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.

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 relationship through the cluster analyses shown below. To isolate the momentum return, we utilized the MSCI USA Barra Momentum Index, since this index neutralizes all other factors. As a proxy for investor sentiment, we used the bull-bear four-week spread for the S&P 500 index. We then evaluated the momentum index relative to the bull-bear spread and top-bottom relative strength quintile dispersion for the S&P 500 index for the period between. As shown in the top panel of CHART 2, there was a somewhat positive but largely insignificant relationship between momentum and investor sentiment (as measured by the bull-bear spread). The bottom panel of CHART 2 shows an equally unconvincing relationship between momentum and relative strength dispersion for the Russell 3000 Index.

Momentum Investing

Momentum Investing

This lack of clustering leads us to believe that the returns of these variables are fairly independent of each other.

We also examined the two-year rolling correlations between the MSCI USA Barra Momentum Index and both the bull-bear spread and relative strength quintile spread in CHART 3 and CHART 4, respectively. This analysis suggests a time varying but inconsistent long-term relationship between momentum and both investor sentiment and relative strength.

Momentum Investing

Momentum Investing

For example, the correlations between the momentum index and the monthly bull-bear spread trended up in 2011 and 2012 before eventually plateauing. This observed increase in correlations resulted from increased market uncertainty emanating from a series of political events that were occurring both in the U.S. and in Europe. On August 5, 2011, in response to Congress’s initial resistance to expanding the nation’s debt ceiling, the S&P downgraded the United States’ long-term federal debt from AAA to AA+ causing Ten-year Treasury yields to fall as low as 2.33% in New York that same day . The underlying reasoning for the downgrade by S&P was a result of “the gulf between the political parties.” The downgrade happened in the midst of rioting in Athens, in response to austerity measures that were being imposed by the so-called “Troika” which comprised the IMF, the ECB and the European Commission. The uncertainty of 2011 continued into 2012, and was compounded by the fiscal cliff debate and a contentious U.S. presidential election. By the end of 2012, Greece was bailed out, President Obama secured a second term and the Federal Reserve extended Operation Twist along with initiating QE3 (online conspiracy theorists’ Mayan calendar hysteria thankfully proved ungrounded). Correlations increased during the first half of the year, but leveled off toward the middle of the year. During this two-and-a-half-year period, correlations moved from .1 to slightly above .6. While there is little evidence of a continuous long-term trend, the key variable which connected the short-term correlations between momentum and investor sentiment was uncertainty. CHART 3 also evaluates the relationship between momentum and investor sentiment and the index of economic uncertainty compiled by Stanford University. The chart demonstrates that the uncertainty index has a leading (or coincident) relationship with their correlation during this time period.

As with the analysis relative to investor sentiment, CHART 4 suggests there is no discernible trend between momentum and the Russell 3000 top/bottom quantile spread. The correlation between these two variables is exhibited in two periods of sharp negative reversals. The first was the 2008 credit and market meltdown and the second occurred between the end of 2011 to the middle of 2013. This latter reversal from a positive to a negative correlation relationship likely reflected the aforementioned mitigation in political uncertainty as well as the impact of market liquidity enhancing monetary policy measures by the Federal Reserve Bank during the period. Consequently, factors such as leverage, book to price, earnings yield that underperformed during 2010 (relative to high quality defensive stocks) were boosted by extraordinary monetary policy measures such as QE 2 and 3 as well as Operation Twist in 2012.

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About FIS Group

FIS Group is an investment management firm that provides customized manager of managers investment solutions for institutional investors. For 20 years, we have delivered risk-adjusted returns by conquering the complexity of identifying high skill, high active share entrepreneurial managers that have gone largely undiscovered by the institutional investor community. Unique among our peers, FIS Group enhances risk-adjusted returns by using macro strategy insights to allocate capital among the managers and/or through a global macro tactical completion strategy. Our culture is a fusion of relentless curiosity and a scientific, disciplined process.

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