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Momentum – the fickle factor

The momentum factor is one of the most frustrating forces at work on our portfolios. Frustrating because it can be a potent return enhancer – yet it has historically been difficult for an ordinary investor to actually exploit.

Momentum is one of the mighty return premiums that sit like gods in the pantheon of portfolio power-ups.

By tilting towards equities that are especially risky, or mispriced (because humans are serial dunces) these premiums have historically unlocked the door to market-beating returns.

Momentum has returned some of the biggest rewards of all: 9.62% annually in the US between 1927 and 2014.

What’s more, it’s been shown to exist in the UK since the Victorian era, and just about everywhere else bar Japan.

Winners keep winning and losers keep losing

So what is momentum?

Momentum is the financial equivalent of a pitch invasion, where everybody crowds around the victors, hoists them shoulder high, invites them home to meet their mam, starts to dress like them, buys their fragrances, asks their opinion on the West Lothian question, and so on.

Success leads to greater success. Meanwhile the losers are shunned, despised, spat at, set upon by dogs…

Put more plainly, momentum is the tendency for winners to keep rising and losers to keep falling over periods of 12-months or less.

A momentum strategy buys the winners while selling or shorting the losers.

Why does the momentum premium exist?

Unlike with the value premium or the small cap premium, few researchers think that the momentum premium is a reward for taking greater risks.

Instead, momentum is about exploiting human weakness – specifically our inability to respond to news quickly and an inclination to under react or overreact to new information.

The idea is that lackadaisical investors digest news over the space of months, rather than incorporating it into the share price in nano-seconds, efficient market-style.

  • Impulsive types might drive prices way beyond fair value while the sluggish might cling on to losers for a while before being forced to concede defeat further down the line.
  • Momentum may also be partly due to forced selling from active funds that fall out of favour, or leveraged investors who face margin calls in bear markets.
  • Yet another cause may be forced buyers who bid up prices further as they try to escape a short squeeze in a bull market.

Regardless of the explanation, the momentum premium has not been arbitraged away in the 20 years since its discovery – although it has weakened to a 6.3% annual return in the US since 1991.

Diversification

What makes momentum even more valuable is its low or negative correlation with other premiums.

Finding negative correlations is the Holy Grail of asset allocation. Holdings that act as counterweights can reduce your portfolio’s volatility when markets are turbulent.

Momentum is particularly interesting to value investors as the two factors have historically been negatively correlated (-0.27% in the US from 1927-2013).

Of course, like all the return premiums, momentum can fail to deliver.

It dished up an unsavoury annualised return of -1.3% a year from 2004-2013, which is a timely reminder that trying to capture return premiums is not a game for the fainthearted.

The momentum everyone’s been waiting for

The biggest problem with momentum is that it’s like a rare herb, with fabled medicinal qualities, buried deep in the Amazon jungle. It’s well known but very difficult to get hold of.

Currently there are only two momentum index trackers available in the UK, and they’re mere hatchlings with no track record to speak of.

Both are available in ETF form:

  • iShares MSCI World Momentum Factor ETF – OCF 0.3%, ticker IWMO
  • db X-trackers Equity Momentum Factor ETF – OCF 0.25%, ticker XDEM

Both ETFs cover the developed world including the UK and apply a formula to identify the highest momentum equities in the MSCI World index over the last 12 months. The equities that are judged to be on fire go into the ETF.

I’ll compare the chops of these two ETFs at a later date, but it’s important to understand that you shouldn’t just plump for the cheapest product and be done with it when it comes to risk premiums.

FTSE All-Share trackers tend to be much alike, whereas there are many different ways to slice a risk factor. Some products may be better than others at creaming off the extra return.

Make sure you understand:

  • How the tracker intends to capture the risk premium.
  • Compare those rules with independent definitions of the factor to try to assess whether it’s going to do a good job.
  • How diversified is the product? Is it so concentrated that it’s more like a bet on certain industries?
  • Is the index independent of the product provider?
  • Is the tracker available at a reasonable cost?
  • Does it have a good track record in comparison to other similarly styled products and indices? (Obviously that’s impossible to gauge for these new products).

If the product provider isn’t transparent about how its flashy smart beta tracker works then forget about it. Also, don’t rush into new products. They often need several months to bed in, so hold your fire until those bid-offer spreads settle down.

Multi-factor options

Given the proliferation of risk factors and firms racing to provide smart beta ETFs to track ’em, most of us will probably find it a lot easier to invest in a multi-factor ETF that combines value, momentum and other factors in one handy package.

If so, then the Amundi ETF Global Equity Multi Smart Allocation Scientific Beta UCITS ETF not only has a name longer than the average Welsh town but also attempts to capture momentum in its dragnet.

Sadly this tracker is only available on the NYSE Euronext Paris for now, but it’s probably only a matter of time before it, and other looky-likey products, are available on the LSE.

Dimensional Fund Advisor fans have no need to fret though as DFA funds already include a momentum screen as part of the service.

DIY momentum

You can capture some of the momentum premium by making sure you don’t rebalance too frequently.

Keep your moves to once a year, or even stretch it to every two years if you can. Or, if you use threshold rebalancing then keep your trigger points relatively slack (for example rebalance when an asset class moves 20-25% from target).

Take it steady,

The Accumulator

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{ 20 comments… add one }
  • 1 dearieme October 14, 2014, 1:48 pm

    “The momentum factor”: this absurd noun “factor” is an invasive weed. I see it everywhere; it seems usually to mean nothing at all. Its verb form “factoring in” is even more loathsome.

    P.S. Momentum isn’t a force; whether a “momentum factor” is a force, GOK.

    Carry on!

  • 2 ermine October 14, 2014, 2:42 pm

    @dearieme although I usually lose a usage and abusage of English debate with you I’d say TA’s use here is okay – momentum is one of the factors in his strategy which presumably has other strands that he hopes will give him a decent return, resulting in a middle finger signal to The Man earlier than otherwise.

    Now as for using momentum as a way to get ahead, well, I have excellent experience of that in the dotcom boom. I marched all my men up to the top of the hill, whereupon it all went wrong very quickly.

    Using momentum presumably involves the element of market timing in knowing when to get off the packed bus before everyone else has the same bright idea…

  • 3 magneto October 14, 2014, 4:53 pm

    @TA
    Thanks for the thoughtful post.

    Quote
    Regardless of the explanation, the momentum premium has not been arbitraged away in the 20 years since its discovery – although it has weakened to a 6.3% annual return in the US since 1991.
    Unquote

    Suppose momentum is unusual in the chartists’ armoury, in that the more people that seek and use momentum, the more it self reinforces.
    Prices go up because they are going up and vice versa.
    As ermine says above it is knowing when to get off the bus, as the first doubts among investors begin to creep in.

  • 4 kean October 14, 2014, 5:34 pm

    I read somewhere recently that if the name of a fund is not decipherable & you cannot immediately grasp its aim OR the manager appears to be trying too hard to impress/differentiate then swerve it.

    “Amundi ETF Global Equity Multi Smart Allocation Scientific Beta UCITS”…….. so have to ask what is “Scientific Beta” about?

  • 5 magneto October 14, 2014, 7:01 pm

    As an aside it is amusing that the use of the word momentum
    = mass * velocity (speed or rate of change)
    has come to be accepted so widespread in the investors’ dictionary.

    Share Prices have no mass as far as I can judge.

    It is a reassuring word for trend followers since to overcome momentum the word suggests we would have to apply an opposite largeish force to stop the momentum, without which share prices would continue on indefinitely rising or falling.
    In practice share prices can turn on a sixpence, which would not happen if they really did have mass.

  • 6 Jeff October 14, 2014, 7:23 pm

    Four questions come to mind with ETFs:

    1 Why are financial companies so keen to offer ETFs if the fees are genuinely as low as claimed?
    2 Why do some tracker ETFs underperform their index by a substantial percentage? I currently just own 1 ETF. If I add underperformance to the fees, it’s costing me over 1% a year over the last 5 years. That just tracks a recognised index, not some momentum index.
    3 This is less common, but in some cases, an ETF tracks the index & it’s difficult to work out where the dividends go to, considering the ETF is not tracking a total return index and not paying out dividends which match those expected.
    4 If the ETF is using “swaps” and the counterparty is part of the bank which offers the ETF, guess who will lose out.

    I shall continue to select good Investment Trusts in preference to ETFs.

  • 7 ChesterDog October 14, 2014, 9:00 pm

    I agree with Magneto.

    ‘Momentum’ actually conveys a quite inappropriate meaning.

    I suggest ‘Bandwagon’ investment. That term seems to encompass the essence of it, including the risk.

  • 8 Greg October 14, 2014, 9:20 pm

    @Jeff
    1) Because they don’t have to worry about keeping track of who owns the units, or have to pay people to to run them.
    2) Because some only sample the index, and some can get diddled slightly during the (rare for cap-weighted ETFs) occasions they rebalance. http://www.morningstar.co.uk/uk/news/66096/the-total-cost-of-etf-ownership.aspx
    Pick Vanguard ETFs for best behaviour. 🙂
    3) Possibly witholding fees. (e.g. Lyxor ETFs IIRC)
    4) You, but again most ETFs have plenty of collateral. Besides, most are physical these days. (Securities Lending is relevant but they get collateral.)

    I hold both ITs and ETFs.

  • 9 Jonny October 14, 2014, 10:16 pm

    A great comment thread. Subscribe me!

  • 10 kean October 15, 2014, 7:54 am

    @magneto, perhaps in this context metaphorically speaking mass = investor exuberance & velocity = speed at which people pile in to invest in a stock/tracker/ETF. :()

  • 11 sceptic October 15, 2014, 10:32 am

    @Jeff

    These would be my answers:

    1 To compensate for outflows out of their active funds + to make a huge sum of money with stock lending + SWAP activities.

    2 Tracking difference can have multiple reasons. Usually the TD equals the TER (- stock lending gains in some cases). Some SWAP ETFs charge a SWAP fee on top.

    3 Tax

    4 The investor. Same with stock lending – you take the risk & the ETF company keeps most of the reward.

    I shall therefore continue to run my own index of individual stocks.

  • 12 grey gym sock October 16, 2014, 12:03 am

    aren’t all factors fickle? 🙂

    all interesting theory, but the only bit i’m inclined to act on is TA’s last point, about being slow to rebalance in the hope of benefiting from momentum while you’re waiting (or at least, avoiding being disadvantaged by going in the opposite direction to momentum).

    on ETFs, let’s not get too bogged down in the issuers’ motives – except perhaps in the case of synthetic ETFs, where IMHO a bit more suspicion is warranted. for most mainstream kinds of investment, you can now get tracker funds or (physical) ETFs which are a lot cheaper than the nearest IT – that’s the major advantage. also, it is a lot easier to understand how a tracker will behave than it is to know what approach an active manager will adopt and how successful it will be.

  • 13 Hamzah October 16, 2014, 10:45 am

    Hmm, you set me pondering with the comment at the end about rebalancing frequency. In cases where one is in accumulation phase with regular cash injection from income or divided reinvestment into the portfolio, is there any advantage to remaining un-invested? I can see the logic for having a generous threshold for top-slicing, but is the strategy to rebalance the poorer-performing components still desirable on a regular basis?

  • 14 The Accumulator October 19, 2014, 5:42 pm

    Ha ha. Thank you the pedant’s brigade 😉 And now for some investing…

    Once the new ETFs have settled down a bit, I think I’m highly likely to invest in momentum due to its negative correlation with value, and low correlation with other factors / forces / styles / anomalies / premiums / phenomena / ephemera…

    @ Jeff –

    1. Because the popularity of ETFs means they can’t afford to ignore them. That said, steer clear of active ETFs, leveraged, inverse, sector specific, and most country specific. Here’s a piece on the specific risks you allude to: http://monevator.com/synthetic-etf-risks/

    2. I second Greg’s comment about Vanguard ETFs. They’re a very snug fit to their index after costs.

    3. Choose an ETF that tracks a total return index.

    4. Choose a physical ETF that doesn’t use swaps or choose a provider that doesn’t do security lending.

    Do IT’s lend securities, btw? I’m genuinely asking because I don’t know.

    @ Hamzah – On remaining uninvested, the evidence is against: http://monevator.com/lump-sum-investing-versus-drip-feeding/

  • 15 DonF September 25, 2016, 8:11 pm

    @ TA: I’m curious, have you bought a momentum ETF yet? And if so, which one?

  • 16 taccumulator September 28, 2016, 6:24 pm

    Hi DonF,

    After a lot of research I concluded that a multi-factor ETF best served my needs. I’ve invested in IFSW and written about it here:

    http://monevator.com/building-a-multi-factor-portfolio-with-ishares-factorselect-msci-world-etf/

    It’s supposed to incorporate momentum, value, size and quality which is the balance I’m looking for. Reputedly multi-factor is more efficient than investing in multiple single-factor funds (e.g. it avoids the cost of selling out of value and buying momentum as stocks migrate).

  • 17 DonF September 29, 2016, 2:39 pm

    Hi Accumulator,

    Thank you for the reply.

    Yes, I’ve been considering investing in IFSW as well. I’m just too tight for its higher TER as I’d eventually like to have a fair part of my portfolio exposed to factors. And 0.22% is less than half of IFSW’s TER…

    Besides, I’ve build up quite a heavy weighting towards value over the last few years (GVAL, IDJV, DGS, SEDY as well as a few individual country ETFs that seemed good value at the time – still waiting for Greece to come good, who knows if that’ll ever happen… 😉
    So I was planning to just start regularly putting new money into a momentum ETF rather than having to switch around too much.

    Decisions, decisions…

  • 18 DonF September 29, 2016, 2:54 pm

    PS: I’d love to read a ‘How to invest in’ article about the various Momentum funds that are floating around. Perhaps even taking into account different asset classes? I really enjoyed the articles about how to invest in the Value and Quality factors.
    Love the website, by the way. I’m a dedicated reader although I hardly ever comment.

  • 19 The Accumulator September 29, 2016, 5:46 pm

    Thanks for the comment, Don F, am I’m very glad you like the site. While you wait for me to get around to momentum, this is a good piece that may whet your appetite for more momentum: http://awealthofcommonsense.com/2015/07/my-thoughts-on-gary-antonaccis-dual-momentum/

  • 20 DonF October 2, 2016, 1:43 pm

    Thanks TA. Very interesting, indeed. It almost seems too good (simple) to be true.

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