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.

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

Good reads from around the Web.

The clever bods at The Value Perspective have been doing a sterling job recently in tackling the weird world of the average and what it means for returns.

From writing here on Monevator, I know a lot of people get confused when it comes to how average returns work in practice – or more specifically about the different kinds of average – and what it implies for our investment decisions, whether it’s asset allocation or investing a lump sum or confronting sequence of returns risk.

And when I say “a lot of people get confused”, I’ll admit that can include me!

So most people could do with a refresher on the maths.

Start with this Value Perspective article on the law of averages, which begins:

Let’s play a game we will call ‘Russian dice’, the rules of which were invented by a physicist/economist called Ole Peters. They are pretty simple – roll a dice and, if it comes up ‘one’, I will shoot you.

Do you fancy playing? It does not sound very appealing but, if you were a nihilistic mathematician, you might be tempted because – in the very strictest terms – on average you will be absolutely fine.

The word ‘average’, however, can be somewhat misleading if not defined very precisely. If 100 people roll the dice instantaneously, the average result is ‘three and a half’ – that is, (1 + 2 + 3 + 4 + 5 + 6) ÷ 6 – so, if you are judging the game on the average result, everyone survives.

However, if I asked you to roll the dice 100 times in a row, it is extremely unlikely you could do so without at some point seeing a ‘one’ come up. Bang. You do not get a chance to see the result of the 100-roll average over time.

Intuitively, we all know there is a difference between these scenarios without any complicated maths or concepts. Mathematically speaking, it is known as the difference between an ‘ensemble average’ (the average of an event happening many times concurrently) and a ‘time average’ (what happens when you do something a lot of times consecutively).

However, this concept and its implications are not well understood in investment.

After that first article provoked a fair bit of debate and confusion, their follow-up tried to explain it with a diagram:

[This time] you simply start off with a stake of, say, £100 in the pot and we toss a coin. Every time the coin comes up heads, you increase what is in the pot by 50%; every time it comes up tails, you lose 40% of whatever is in the pot.

The coin is a fair one – so it is always a straight 50/50 chance – and there is not a firearm in sight.

Would you like to play?

At first sight, there appears to be no reason not to play – after all, if on each coin toss the only two possibilities are going up 50% or falling 40%, then surely, on average, it is a winning game. And indeed it is. No matter how long you play it for, on average, the expected return is positive – but, as we argued in the previous article, the word ‘average’, if not defined very precisely, can be misleading.

In this particular example, the average obscures a pattern where the majority of people who play the game actually end up losing.

Here’s the pattern:

It reveals:

In the above example, 11 of the 16 possible sequences of coin tosses are losing permutations and, the longer the game goes on, the more money is lost.

In a game where the only possible outcome each time is a 50% upside or a 40% downside, that would appear counter-intuitive so what is complicating matters?

It is that difference between time and ensemble averages.

Read the whole article for a deeper explanation.

[continue reading…]

Some critics of passive investing say there’s “no such thing” as truly passive investing. They point out that even an investor who only uses index tracker funds has to decide:

• How to split their money across the various asset classes.

•  Which indices / trackers are the best in each class.

• How and when to rebalance their portfolios.

• Which platform to opt for, and whether to use ISAs, SIPPS, or both.

• What to buy the in-laws for Christmas.

That’s all true enough (especially the last one).

After all, Monevator is a site mostly about unwrapping the mysteries of passive investing. If such investing was utterly without nuance, we could have saved ourselves 1,000-odd articles over the past seven years!

But so what?

For every decision you need to make as a passive investor, someone else is making dozens if not hundreds as an active investor – almost by definition.

An active investor complaining that passive investing involves a lot of tricky decisions is like an air traffic controller being befuddled by a zebra crossing.

Moreover passive investing can be as complex or as simple as you want it to be.

My standard advice to new investors has long been to put half their monthly savings into a high interest savings account and to invest the other half into a broad index tracker fund. Do that in an ISA or SIPP, repeat for 30 years, evolve as you learn more, and I’m confident you’ll get a good result.

You could even use a Vanguard LifeStrategy fund and skip the cash bit.

Is it the perfect passive strategy? Probably not, but it’s super easy-to-implement, logic is on its side, and it’s inordinately easier than implementing an active strategy over 30 years – never mind actually beating the market by doing so.

Market cap trackers are just fine

That’s all a long-winded way of saying that straying from a bog-standard basket of market cap weighted index tracker funds is decidedly optional.

Indeed, our current view around here is that there’s no magic in Smart Beta or equal-weighted indices. You’re simply taking on more risk for hopefully more reward, and in most cases you’ll also face a headwind of higher costs for doing so.

And while we’re all for considering tilting your portfolio towards value shares or small caps, we’ve stressed such factor bets are no slam dunk to outperformance.

As such, they can safely be left in the ‘too hard’ pile if you want without any danger or feelings of foolishness.

You see, even the experts don’t agree about these issues, as this latest video from Sensible Investing reveals:

As the Nobel Prize-winning economist Professor Eugene Fama says:

“The overall cap-weight market portfolio – including everything, not just stocks – model is always a legitimate portfolio.

In any asset-pricing model it’s always one of the so-called efficient portfolios.

But if you take, for example, our work seriously, what it says is there are multiple dimensions of risk and you can tilt towards these dimensions, so you can move away from the market portfolio towards these dimensions.”

In other words, start with the simplest, broadest vanilla trackers, and then research and invest where your passion takes you – and if that’s to the conclusion that simple is best after all, then that is absolutely a-okay.

Check out the rest of the videos in this series so far.