"Fact, Fiction, and Momentum Investing" ~ Dual Momentum

04.11.14 08:45

"Fact, Fiction, and Momentum Investing"

The AQR posse (Asness, Frazzini, Israel, and Moskowitz) recently issued a working
paper that disproves many often-repeated myths about momentum investing,
particularly as it applies to individual stocks. The authors back up their reasoning
with results from academic papers and publicly available data. Here are the myths
they address:
The momentum anomaly is small and sporadic
It works mostly on the short side
It works well only among small stocks
It does not survive trading costs
It does not work for a taxable investor
It is best used as a screen rather than as a regular investment factor
Its returns may not persist
It is too volatile to rely on
Different measures of momentum may give different results
There is no theory or reasonable explanation to support it
Below is a quick summary of the authors' evidence-based counter arguments:
1) There is overwhelming evidence from scores of studies showing that momentum
returns are remarkably stable and robust.
2) There is little difference in performance between the long and short sides of
momentum based on factor model regressions. Based on average returns versus the
market, the long side has contributed more to momentum profits.
3) As for working only among small caps, this is true only if you replace the word
"momentum" with the word "value". Two of the authors, Israel & Moskowitz, wrote
an important paper last year called "The Role of Shorting, Firm Size, and Time on
Market Anomalies" that clearly showed this. That paper was the subject of my post,
"Momentum...the Only Practical Anomaly?" Momentum actually works well across all
size stocks.
http://www.dualmomentum.net/2014/06/fact-fiction-and-momentum-investing.html

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"Fact, Fiction, and Momentum Investing" ~ Dual Momentum

04.11.14 08:45

4) A study last year by three of these authors called "Trading Costs of Asset Pricing
Anomalies" looked at large institutional trades across nineteen developed markets
from 1998-2013. They found the trading costs of momentum to be low, despite a
higher turnover than from other factors.
5) Several studies show that even though momentum with individual stocks has 5-6
times the annual turnover of value strategies, momentum actually has a similar tax
burden. This is because momentum holds on to winners and sells losers, which avoids
short-term gains in favor of long-term ones. Momentum also has a much lower
dividend exposure than value.
6) The authors point to papers showing that momentum works better as a factorbased approach than as a screen-based one.
7) As for momentum's returns disappearing, one can say the same of any anomaly.
Abnormal momentum returns have survived, however, for the past 212 years.
Momentum has held up to considerable out-of-sample validation across time,
geography, and asset type. The authors point out, "There is no evidence that
momentum has weakened since it has become well-known and once many
institutional investors embraced it and trading costs declined."
8) Relative strength momentum is volatile, but the Sharpe ratio (which includes
volatility) of momentum still comes up on top. The authors say, "Who are you calling
small and sporadic?" (The authors ignore absolute momentum, which significantly
reduces expected volatility and drawdown.)
9) The authors agree that different measures of momentum can give different results,
but they point out that this is true of any strategy. Different measures of momentum
giving good results is a sign of robustness and not a cause for concern.
10) Momentum can be explained by either risk based or behavioral factors. As long as
risks, risk preferences, biases, and/or behaviors do not change, momentum profits
should continue unabated as they have for the past 200+ years. (My forthcoming
book shows how behavioral biases are part of our DNA and are unlikely to change.)

http://www.dualmomentum.net/2014/06/fact-fiction-and-momentum-investing.html

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"Fact, Fiction, and Momentum Investing" ~ Dual Momentum

04.11.14 08:45

The authors point out that most of the above myths can be shattered by a quick visit
to Kenneth French's data library website. It is refreshing to see the authors, brought
up in the Chicago efficient markets tradition, take on the challenge of those who say
momentum profits cannot persist (despite plenty of evidence to the contrary) because
that would contradict the theory of efficient markets. The authors point out that
rejecting data because of a theory (or a one-sided view of the world) can be
dangerous. They point to Columbus, Galileo, and the Salem witch trials as examples.
Bravo!
The only problem I have with their paper is that the authors, perhaps keenly aware
that risk-adjusted momentum profits from individual stocks have been uninspiring
over the past thirty years, repeatedly point out that momentum works best when it is
combined with value. Yet we can see in the aforementioned Israel & Moskowitz study
that commonly used measures of value hold up only among the smallest stocks that
represent only 10% of total market capitalization, and these are impractical for most
investors to hold. Maybe the AQR crew needs to take a closer look at the true value of
the emperor's new clothes.

http://www.dualmomentum.net/2014/06/fact-fiction-and-momentum-investing.html

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