Value and Momentum Everywhere - the ultimate market strategy?

Wednesday, Oct 31 2012 by
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Value and Momentum Everywhere  the ultimate market strategy

Value investors generally have to be a tenacious bunch. While everyone knows that value will out in the long run, in the short run it seems to have a torrid time. Within these long periods of underperformance lies the risk that value investors lose their careers in the process - a grim prospect for many. Warren Buffett himself underperformed the market during the dot com bubble by something like 70%. Luckily for him he had the record and authority not lose his job. Others like Tony Dye at the time had no such luck. The risks that value investors deal with in pursuing their strategy are very real. But what if there were a way to mitigate these risks?

In 2008, Cliff Asness, Goldman Sachs alumni and founder of the big quantitative hedge fund AQR Capital, published a research paper titled "Value and Momentum Everywhere" that holds some hope for those value investors willing to broaden their remit. Most investors who've been around markets know that over the long run both value investing and momentum investing work, but something extraordinary appears to happen when they are baked together.

Building the combined value & momentum portfolio

Asness et al decided to study a combined portfolio weighted 50% towards a value strategy, and 50% towards a momentum strategy across a range of asset classes and geographies. Most previous studies had only investigated either value or momentum on their own, usually in an isolated asset class or geography. By investigating 'Value and Momentum Everywhere' the authors were able to highlight a completely global phenomenon - that value and momentum, when brought together create quite remarkably strong returns with remarkably low volatility.

Across the US, UK, Europe and Japan they looked at portfolio returns in not only traditional stock portfolios but also index stock portfolios, currencies, commodities and bonds. Each portfolio was constructed to be market neutral - for the stock picking strategies this meant being long cheap stocks and short expensive stocks (by price to book) and long recent momentum winners and short losers (by 12 month price return). Microcaps, closed end funds, financials and REITs were excluded.

Asness et al found that momentum and value strategies not only provide strong returns, but that they are negatively correlated. What this means in plain english, is that when one strategy works well, the other lags, one zigs when the other zags. Intuitively then, if both strategies are profitable individually, when combined you'd expect the resulting strategy to create a smoother profit line, as the volatility of each components cancels the other out. This is precisely what they found. The combined strategy displays extraordinarily smooth returns not only within single asset classes but also across them. It appears that value combined with momentum works literally everywhere, even during the dotcom bubble that completely devastated value investing returns all over the world. The charts below tell the story quite clearly.

What drives value and momentum?

Why would this phenomenon happen? The study found that value and momentum are only slightly positively influenced by macro-economic factors like GDP growth and only mildly negatively influenced by recessions - "the statistical relation between these macroeconomic indicators and value and momentum strategies is weak". They also looked into the idea that market liquidity risk could be a driver but found that while value strategies suffered during times of financial distress, momentum strategies were enhanced, only "deepening the puzzle".

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They then proposed an explanation hinging on the difficulty that arbitrageurs might have in certain market conditions of repricing securities. Personally, that explanation was a little beyond me. I lean towards the behavioural idea that in aggregate investors globally may have a tendency to price stocks badly, creating markets that just aren't efficient - that explains the persistence of these returns enough for me without getting too academic!

Interestingly, the short portfolios contributed enormously to the overall returns. In fact, in the stock selection strategies they found that 60% of profits were driven by short sales of expensive stocks, and 60 to 70% of profits from short selling momentum losers. On the other hand, while the long side of the portfolios are less profitable, they do make up some of the ground by providing better diversification benefits to the portfolio as a whole, smoothing the eventual returns.

United we stand, divided we fall?

These results ought to be quite eye opening for gritty value investors. Instead of clinging to (often rather ugly) value stocks solely on the long side, they ought perhaps to recognise that they are wedded to a single return driver that doesn't work all of the time. If they were to diversify across the uncorrelated and complementary return driver of momentum and hazard on occasion to the short side then they may have better and more consistent results. While not all of us can easily and systematically put a strategy such as the one outlined in the paper into practice, there's a huge amount of food for thought there. It's a long paper and I've hardly scratched the surface in this article but highly recommended.

While Asness et al only modelled value in terms of Low Price to Book in order to maintain a 'simple approach that is consistent across asset classes', he does mention that there are more powerful stock selection strategies for value investors including those of Joseph Lakonishok and Josef Piotroski. For those keen to implement value and momentum strategies in these ways our stock screener models these techniques.

 

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6 Comments on this Article show/hide all

dangersimpson 2nd Nov '12 1 of 6
6

Hi Ed,

Interesting article. As a mostly long, bottom up stock-picker I think the key to understanding and profiting from the momentum effect is to understand the fundamental and psychological reasons behind them. I don't believe that momentum effects are purely technical analysis (in the sense that future prices are a function purely of past prices) but are actually under and over-reactions to fundamental events such as earnings announcements or corporate action.

In the very short term (c. 1 month) stocks tend to exhibit mean reversion. A large fall due to bad news tends to be reversed as anchoring effects lead investors to believe that (rightly or wrongly) it is now good value. The converse of this is people selling an ‘overbought’ stock.

In the medium term (c. 1 year) stocks tend to exhibit momentum. Essentially corporate out-performance tends to be serially correlated with further out-performance. Companies tend to hold something in reserve when they trade exceptionally well or badly, analysts are slow to upgrade estimates. Hence share price movement tends to be serially correlated as positive or negative earnings surprises continue.

In the long term (c3 years) stocks tend to mean revert as people tend to over-extrapolate the performance of the company over the previous years. They underestimate the extent that a company earning excess returns will generate competitors who seek to capture that excess return or the pressure a company that is struggling will face to turn itself around.

It is this long term mean reversion that most value-investors aim to capture although the preferred measures are usually ones of cheapness such as P/E, P/B, EV/EBITDA, P/FCF etc. rather than price action itself. The tool that most use is patience – e.g. Dremen ‘buy a basket of cheap stocks and hold until they are re-rated’. But there are potential ways to improve this method by identifying cheap companies with a sustainable moat (Greenblatt, Montier) or ones that have the balance sheet strength to survive the turnaround (Piotroiski.)

However there is no reason why value investors cannot use the other momentum affects. In many ways the ideal investment is a cheap company (3-yr mean reversion) that is temporarily available at a discount price (1m mean reversion) but is beginning to beat market expectations (1yr momentum). I guess these may be described as ‘turnaround investments’ by some and often generate some of the best IRR’s if you can successfully pick them.

The benefit of looking at the fundamental reasons behind the momentum affects IMO is that you tend to avoid the big losses associated with chasing bubbles on momentum or the ‘momentum crashes’ that you highlighted in a previous article.

Of course the other method that combines value & momentum is the ‘expected-return factors models’ we discussed a while back. I believe that 1m & 3yr RS are negative significant factors in Haugen’s published work and 1yr RS a positive significant factor along with the usual valuation metrics of Book/P, FCF Yield, Earnings Yield, Div Yield, & ROCE.

Cheers,

Danger

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Edward Croft 2nd Nov '12 2 of 6
2

In reply to dangersimpson, post #1

Hi DS, thanks for the comment. Expected return factor models are some way out just now -  I just read a great piece by Cliff Asness which I recommend - see here   I've hacked together this image of the momentum/value 'return surface' - from his paper.  Am planning on writing up more fully... but you can see that cheap stocks returns improve somewhat by adding 12m momentum, but not as much as you'd think. There are a few striking thinsg on that chart - the back wall... high momentum stocks do just as well if expensive or if cheap.  the front wall -  value effect works best for loser stocks.  the left wall... get out of expensive stocks quickly once they start to fall !

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dangersimpson 3rd Nov '12 3 of 6
3

Interesting linked article thanks. A few thoughts...

I wonder if the reason they exclude the performance of the last month is due to the short term mean reversion effect I mention?

Also am I right in reading this study as measuring the impact of momentum and value on the next months stock return?

If so I'm not surprised to see that momentum strategies are dominant over such a short timescale. However how many of us re-balance our complete portfolio every month with the associated costs?

I would expect that if it measured excess return over a longer period it might be a bit more balanced between momentum and value although that's just a feeling I haven't got empirical evidence to back that up.

Since most of us are aware of what the sources of excess return are one of the biggest challenges we face as investors is building a portfolio that delivers the best return after correcting for costs which are not fully accounted for in studies like this. There is an inherent trade off between turning over your portfolio quickly to account for changes in the factors that drive expected return and the costs of doing so. Likewise there is a trade off between investing in small companies where PI's can have a competitive advantage and the large spread that exists for illiquid stocks.

This paper considers value and momentum strategies, doesn't seem to combine them, but does consider variable measurement and holding periods:

http://118.96.136.228/ejurnal/JFE%202004%2073%203/JFE%2004%2073%203-5%20Testing%20market%20efficiency%20using%20statistical%20arbitrage%20with%20applications%20to%20momentum.pdf

While the maths is a little bit beyond me on a skim read (or maybe ever!) table 2 seems to suggest that the optimum momentum strategy is 9 months measurement and 6 months holding period. It would be good to see this sort of momentum strategy broken down by value deciles...I'll keep googling :-)

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Edward Croft 4th Nov '12 4 of 6
2

DS - you are right about the recent month exclusion.

From memory I think they tested 1 month and quarterly holding periods. I have an excellent Soc Gen piece that showcases the WISE strategy - it joins Value with Momentum in 1 year holding period portfolios - a good balance between the longer holding periods often essential for value investing and the short holding periods for momentum. It has performed very robustly over the last decade - they publish it for all geographies.

Regarding transaction cost research... if you do dig up good material please let me know. We are writing a short e-book on momentum at the moment, so it would be great to factor it in. I haven't read this one - but this is a start http://j.mp/Rzc7AQ

Blog: Follow @edcroft on Twitter
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Sanda 6th Nov '12 5 of 6

From memory, GMO use both momentum and value in constructing their portfolios. Their website is worth a look.

Good material above - thanks.

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frogtiper 18th Feb 6 of 6

Very good though I am not yet able to make much use of it yet because of my ignorance.

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About Edward Croft

Edward Croft

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CEO at Stockopedia where I weave code, prose and investing strategies to help investors beat the stock markets. I've a background in the City and asset management but now am more interested in building great stock selection tools for the use of investors online.   Traditionally investors online have had very poor access to the best statistics, analytics and strategies for the stock market and our aim is to set that straight.  High Quality fundamental information has been prohibitively expensive in the past and often annoyingly dull. People these days don't just want to know the PE Ratio and look at a balance sheet. They expect a layer of interpretation over data, signal from noise and the ability to know at a glance whether a stock is worth investigating or not. All this is possible using great design and the insights gleaned from quantitative research.  Stockopedia is where we try to make it happen ! more »


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