Published just last week, "Fact, Fiction and Momentum Investing" seeks to put momentum skeptics in their place. It is not shy in doing so. In many instances, state the authors (Clifford Asness, Andrea Frazzini, and Ronen Israel of AQR Capital Management and Tobias Moskowitz of Chicago Booth), their decision to use the term "confusion and debate" about the momentum-investing discussion is "us attempting to be polite, as it is near impossible for informed practitioners and academics to still believe the myths uttered about momentum."
They get scrappier yet on the next page. "Anyone repeating these myths, in any dimension, after reading this piece is simply ignoring the facts." (Taking the boy out of New York is one thing; taking the New York out of the boy is quite another.)
Momentum investing, as a reminder, seeks to profit by purchasing securities that have recently performed well relative to their peers and/or shorting securities that have recently fared poorly.
The 10 myths about momentum, according to the paper, along with the authors' responses:
1) Momentum returns are too "small and sporadic."
[Momentum] is present in U.S. stocks over very long time periods and following its academic "discovery" in the early 1990s, has been shown to be robust out-of-sample (an important exercise we will repeat here), in the individual stocks of other countries, for stock markets, and for completely different asset classes, such as bond markets, currencies, commodities, and others.
2) Momentum cannot be captured by long-only investors as "momentum can only be exploited on the short side."
Those repeating this myth are asserting that most or all of the returns we show above for UMD [up minus down, i.e. Momentum] come from being short the losers. This is patently and clearly false ... momentum does not work better, or only, on the short side.
3) Momentum is much stronger among small-cap stocks than large caps.
What it lacks in truth it makes up for with the amusing quality of being backwards at least when uttered (as is often the case) by fans of value investing--this myth happens to be true if you replace the word "momentum" with "value." [Momentum] is almost equally strong among large caps as it is among small caps.
4) Momentum does not survive, or is seriously limited by, trading costs.
Paraphrasing. First, this probably is true for individual investors, who on average have trading costs that per the paper are 10 times higher than that of a large institutional manager. (You should not feel comforted by that.) Second, the claim assumes brain-dead, automated trades, rather than an intelligent implementation.
A firm like DFA ... is far smarter than to trade blindly to a set of dynamically changing strategy weights when even small modifications can greatly reduce costs.
5) Momentum does not work for a taxable investor.
Momentum, despite having five to six times the annual turnover as value, actually has a similar tax burden as value. Momentum actually has turnover that is biased to be tax advantageous--it tends to hold on to winners and sell losers. Value strategies, despite their low turnover, have very high dividend income exposure. Momentum, on the other hand, more often than not has low dividend exposure. On net, this makes value and momentum roughly equally tax efficient.
6) Momentum is best used with screens rather than as a direct factor.
This argument follows from the earlier beliefs. If momentum investing is a small effect, limited mostly to shorting, hampered by tax and trading costs, and mostly a small-company effect, then it is too weak to serve as a direct factor for an investment strategy. Perhaps, though, it can function as a secondary screen.
Since momentum is very strong ... using momentum as a screen will be significantly suboptimal versus using momentum as a factor.
7) One should be particularly worried about momentum's returns disappearing.
We remember 1999-2000 when investors were abandoning value investing, many with the belief that it would never work again because "the world had changed" ... there is no evidence that momentum has weakened since it became well known and once many institutional investors embraced it and trading costs declined.
8) Momentum is too volatile to rely on.
As with any factor, momentum does not make money all the time and occasionally suffers large losses, and historically this has been somewhat worse for stand-alone momentum than the other factors discussed here. Spring 2009 was one of those times. But, while more extreme, this isn't unlike other factors. There is a saying at the University of Chicago, "the plural of 'anecdote' is not 'data'." Neither 2009 for momentum nor 1999 for value are indicative of the overall health and strength of these strategies.
9) Different measures of momentum can give different results over a given period!
OK, this isn't a myth, it's actually true, but it's tritely obvious and yet still often hurled as a critique of momentum so we've chosen to include it.
10) There is no theory behind momentum.
Actually, there are several theories--the real issue is that the leading theories for momentum appear to be behavioral, rather than with size or value, based on the higher risk of those securities. (Let's set aside whether that higher risk exists; the point is, the theories are a claim for risk.) The authors address the behavioral aspect as follows:
The idea is that if the momentum premium is really as large and robust as we show it to be, then it must be due to a market inefficiency and therefore (and here's where the religion comes in) it can't be real, as the markets are obviously perfectly efficient. While we believe that risk-based efficient market explanations play an important role in all of these factors' returns [i.e., size, value, momentum], we also believe there is a role in each, perhaps at different degrees, for behavioral explanations.
My views
Clearly, the paper is the latest salvo in a battle fought between value- and momentum-factor investors. (Actually, AQR invests in a wide variety of factors and would no doubt write an equally vigorous defense of value if the need arose. However, momentum tends to take more potshots, being the newer strategy.) It states its case effectively and for the most part dispenses with the myths.
I do have three comments.
1) Trading and tax costs are problems for the retail investor. That objection lies outside the scope of the paper, which is about institutional investing, but it nonetheless deserves a mention.
2) The second is the eighth point, that the gains from momentum investing are too volatile. As the authors concede, that claim is not entirely a myth, because as factors go, momentum is among those with the longest dry spells. If that is a significant problem or merely a minor annoyance depends on the investor's risk tolerance.
3) The third concern is the carefully worded final point. It is indeed a myth that there is no theory behind momentum. On the contrary, there are many theories. However, whether those theories adequately explain the momentum factor's success is a debate that remains unsettled. (That would be a fine topic for a future column.)
Finally, a salute to the authors for writing an eminently readable paper. Between that and the mathematicians' article in last week's Taboo Talk: Why momentum investing is a dressed up version of technical analysis column, I've been quite entertained.
John Rekenthaler is Vice President of Research for Morningstar. This article initially appeared on Morningstar's U.S. website.
