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Does Momentum Have a Future in Risk-Factor Investments?

Momentum investing as a game of hot potato—should it be in institutional investors’ portfolios?

(August 22, 2013) -- Momentum is one of the four commonly accepted risk factors, but investors should be aware that the strategy is on downwards performance trajectory, research has found.

Although the strategy outperformed the other three riskfactors (market beta, value, and small size) in the recent past—January 1970 to June 2013—in terms of both absolute return and Sharpe ratios, Research Affiliates have shown since 1990, momentum has produced a negative risk premium.

“As attractive as momentum appears… it must be borne in mind that all equity risk factors are time-varying. That is, risk factor exposures will not add value consistently and all of the time,” a note from Ryan Larson from Research Affiliates said. “There will be some periods when certain risk factors are in favor and others when they are not—including extended intervals when factor-based investing is very discomfiting.”

Larson’s note had further concerns about the strategy; not least the additional volatility brought into a portfolio by the use its use.

“Although momentum and value factors have similar Sharpe ratios over time, momentum has 50% higher volatility, whereas value is more stable and, perhaps, more intuitively appealing,” he said.

Larson likened the strategy to a “hot potato” as investors bought rapidly appreciating stocks, holding them for a short time then selling quickly as prices reversed.

Due to this characteristic, trading costs were also a concern for investors, Larson said, citing a paper that showed long/short portfolios could have up to 170% annual turnover, which could “substantially erode the risk premium due to momentum”.

The major problem, however, was the lack of empirical evidence for why the strategy should exist at all. Larson’ added that there wasn’t a general accepted theory that explained the theory behind momentum in financial markets.

“In the face of uncertainty, individuals estimate the expected future value of an asset by making adjustments to a reference price, that is, an ‘anchored’ value,” he said. “Investors manifest this tendency by anchoring to the current information (stock price) and being slow to adjust expected future values in light of new information. Thus, prices lag fundamental information and play ‘catch up’ for a few quarters, leading to serial correlation in stock prices.”

Larson concluded investors could use the approach, but as an “add-on” to an existing investment portfolio strategy due to its instability and precipitous nature.

To read the full paper, click here.

Related content: The World’s Longest Backtest (and What it Shows about Momentum Investing)  

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