Quant Momentum Strategy Is Being Maligned Unfairly

(Bloomberg Opinion) -- The two oldest investment strategies are to buy things that are cheap (value) and buy things that are going up (momentum). These ideas long predate modern financial theory and were as popular among cigar-chomping, shirt-sleeve, high-school-dropout traders in the Chicago pits as the pipe-smoking, tweed-jacketed PhDs in the University of Chicago faculty club.

A recent paper — “A Look Under the Hood of Momentum Funds” by Federal Reserve  economist Ayelen Banegas and University of Calabria researcher Carlo Rosa —  attacks momentum investing using a curiously circular argument. Momentum has performed badly during the pandemic era, principally because trends keep reversing. The market crashes in March 2020 and then rebounds almost immediately. The first Covid-19 wave in the spring of 2020 sends investors fleeing energy, travel and movies in favor of healthcare, streaming and on-line shopping.

But then the first wave recedes rapidly while the government floods markets with liquidity and sectors realign. Just when you think it’s safe to throw away your mask, the second and massive third waves hit. But then vaccines appear faster than anyone expected to save the day. But after widespread vaccination, 2022 death rates are almost as high as the third wave peaks, in fact the fall of 2021 wave merges into the 2022 wave with little reduction in between.

Momentum investors realize there are periods of reversals, but over the long run betting that things will continue like the recent past is like being the casino in roulette. You lose a lot of bets, but you win more than you lose. This has been proven over many decades in many markets — stocks, bonds, currencies, commodities, credit, etc. And there are many flavors of momentum — time series (buy stocks when the market is going up, get out or go short when it’s going down), cross-sectional (buy the stocks that went up most over the last year, short the stocks that went down the most) and fundamental (buy companies whose earnings or other metrics are increasing, short the others).

The authors agree that momentum has long and broad statistical support but complain that it’s done badly recently. However, it’s only momentum investors who believe that recent performance is the way to judge investments. If you don’t believe in momentum, you wouldn’t evaluate a strategy based on what it’s done lately.

We can put some numbers on this using academic momentum. This is a portfolio based on research by Eugene Fama and Ken French, and published on French’s website. Omitting some technical details, the momentum portfolio is composed of buying the 30% of stocks with the highest returns from 12 months to one month ago (so on Feb. 14, 2022, you look at returns from Feb. 14, 2021 to Jan. 14, 2022) and shorting the 30% of stocks with the lowest returns. This portfolio has generated a 6% annualized return above the risk-free rate of interest since 1926, with an annualized standard deviation of 12.6%. The ratio of those is called the Sharpe ratio, and is 0.48.

The momentum portfolio has significantly outperformed the stock market, which had a 0.39 Sharpe ratio over the same period. But momentum’s real value is that it has a negative correlation with the market. If you add a momentum portfolio to the market (basically meaning you double-weight the 30% of stocks that went up the most, market-weight the middle 40%, and ignore the bottom 30%) your Sharpe ratio jumps to 0.69 because you get a lot of extra return but only a little extra risk due to the negative correlation. Since April 2020, the story is not pretty. The academic momentum portfolio has lost at an annualized rate of 19.8%. Adding momentum to the market has yielded a Sharpe ratio of only 0.43. It’s been a two-year losing streak for the house.

The authors’ contribution is to create a practical momentum portfolio by tracking passive exchange-traded funds with the word “momentum” in their names. These funds do not short stocks, so they’re comparable to academic momentum plus the market rather than to academic momentum alone. Each fund has its own method for defining momentum and must deal with practical issues like rebalancing frequency and transaction costs. While we wouldn’t expect actual ETFs to match academic portfolios exactly, the general failure of momentum over the last two years means we wouldn’t expect these ETFs to have done well.

The authors report results for 2015 to 2021, but this is misleading. There are only 22 ETFs in their sample, with an average of 26 months of data each. Nearly all their data comes from the last two years and represents a tiny sliver of the momentum strategies in the market. They do find that using momentum funds reduced investor returns from 15.2% per year in an index fund to 14.4% with index plus momentum fund, and it also increased standard deviation slightly, so the Sharpe ratio fell from 0.95 to 0.86. A more sophisticated regression that adjusts for the effect of academic momentum shows a smaller loss from adding momentum ETFs to an index portfolio, 0.4% rather than the 0.8% above.

What to make of this work? Well, you could say you don’t believe in momentum, so you don’t want the momentum ETFs anyway, regardless of recent performance. Or you could say you believe in momentum, so you’ll wait until these ETFs start doing well before buying them. I think you should pay attention to the long-term, cross-market evidence for all flavors of momentum and make sure your portfolio has a healthy exposure to all types. Going all in on one type — cross-sectional momentum in U.S. stocks — can mean experiencing deep periods of drawdowns over several years. But diversified momentum for the long-term is among the most reliable bets we know in finance.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Aaron Brown is a former managing director and head of financial market research at AQR Capital Management. He is the author of "The Poker Face of Wall Street." He may have a stake in the areas he writes about.

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