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Understanding The ‘Momentum’ Factor in Smart Beta Investing

Posted on: 16.11.2016

Momentum is a common factor in nearly all Smart Beta strategies. Momentum investors seek to ride a wave of strong performance by using recent three to twelve months data to make decisions on which stocks to sell and which stocks to buy. This practice is inherently risky because it’s focused on a narrow period and eschews the modern notion of the efficient-market theory.

A CFA publication, Investment Risk, and Performance echoes this sentiment of risk. The author warns, “Portfolio managers who pursue the long-term benefits of exposure to the momentum factor may place the portfolio’s value at risk when momentum results or market returns change direction, potentially upending the benefits of a recent positive exposure to momentum stocks.” The occasional practice of short-selling declining stocks amplifies the risk of momentum investing. Short-selling is exceedingly risky because there is no limit to the trader’s downside risk. In short, a momentum trader believes current trends will persist. This short-term strategy is in contrast with long-term methods like value investing.

University of Chicago professor Eugene Fama and Dartmouth professor Ken French examined data on a momentum style stretching all the way back to 1927. Their review of monthly fluctuations yielded some revealing insights. They calculated the return of a hypothetical portfolio designed to capitalize on the stocks representing the top 10% of returns over the trailing 12 months. An article in Barron’s reports these findings, stating, “On average since the late 1920s this hypothetical portfolio gained 15.1% over the three months prior to bull market peaks—equivalent to a 75.8% return on an annualized basis. But this portfolio gave almost all of that back in the three months after those peaks.” Gains vaporize fast. Additionally, rapid-fire trading incurs ever-increasing costs which further defray returns.

Academic results are compelling, but real world application always tells a more truthful story. We can see the effect of this strategy in a real market setting by reviewing the long-term performance of the iShares Edge MSCI USA Momentum Factor ETF (MTUM). The fund seeks to track U.S. large-cap and mid-cap stocks exhibiting strong momentum. The fund has seen significant appreciation since it’s inception on April, 16th 2013. Over this period MTUM returned 51.87% whereas the S&P 500 returned 37.55%. With a reasonable expense ratio of 0.15% the evidence for the inclusion of a momentum play in a portfolio is compelling.

Ishares US Momentum (MTUM) has outperformed the S&P 500.

Ishares US Momentum (MTUM) has outperformed the S&P 500.

A wider data set suggests this approach works best with a long-term commitment. A greater number of momentum funds outperform the market with a horizon of 15 years rather than 5 or 10. Volatility here runs high. Wild movements are the result of decisions based on limited periods (e.g. three months) rather than long-term price performance or a careful review of a companies fundamentals.

Some have attempted to curtail volatility in momentum funds with sector rotation and options trading. In most cases the effect of reduced fluctuations is nominal. A momentum style should be considered as a component of a multifactor Smart Beta strategy rather than a singular focus.

Corey Philip

Corey Philip is the founder of RealSmartBeta.com. His focus is on expanding investor knowledge of Smart Beta ETFs and quantitative investing. Learn more about Corey in the 'ABOUT' section of this website.

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