Momentum trade is market's short-term steamroller
BREAKINGVIEWS-Momentum trade is market's short-term steamroller The author is a Reuters Breakingviews columnist. The opinions expressed are his own.
By Edward Chancellor
LONDON, July 17 (Reuters Breakingviews) - In the investment world, the practice of blindly following market trends is known as momentum. When it takes off, investors who select stocks based on fundamental criteria start to trail their benchmarks. Disappointed clients take their money elsewhere. The temptation for the value fund manager to capitulate becomes overwhelming. The travails of Fundsmith, the UK investment firm, illustrate the dilemma. The trouble is that when the bubble bursts, the belated decision to join the herd usually turns out to be a costly mistake.
Buying stocks that have recently outperformed has a long track record of delivering positive returns. Quantitative investors use momentum as a counterweight to their value-based picks. As the veteran investor Jeremy Grantham writes in “The Making of a Permabear: The Perils of Long-term Investing in a Short-term World” — which I helped to compile — momentum is the yin to value’s yang. When value-based trades perform poorly, having an allocation to momentum stocks reduces a portfolio’s deviation from its benchmark. That helps to keep clients on board.
Grantham, however, has concerns about momentum. When top-performing stocks disappoint, losses are permanent, while value stocks generally recover. Paul Woolley, his former colleague at the investment firm GMO goes much further. Nearly twenty years ago, Woolley sponsored a centre at the London School of Economics to study capital market dysfunctionality. Together with the centre’s director, Professor Dimitri Vayanos, the former fund manager has written several papers elaborating the damage done by momentum. (Their research is accessible through an AI-curated database, ask.ricardoresearch.ai.)
Vayanos and Woolley argue that, contrary to modern finance theory, markets dominated by momentum are inherently inefficient. Trend-following, they say, involves buying high and selling low. Its focus is short-term, whereas value investing concentrates on long-term fundamentals.
When momentum dominates the market, investment flows, not rational calculation, determine prices. Share prices are driven away from fair value. In finance theory, investors are supposed to earn superior rewards for taking more risk. In reality the most volatile stocks have produced subpar returns. This inversion of risk and return is caused by momentum, say Vayanos and Woolley.
Most risk measures employed in the investment world assume that markets are efficient. That’s why investment performance is judged relative to an index. But when investors seek to reduce their tracking error, they are forced to sell their underperformers and buy stocks whose weight in the benchmark has risen. That’s momentum, says Woolley.
Look hard enough and you will find momentum in every nook and cranny of the market. It’s not just funds that overtly select stocks based on their recent outperformance (what Woolley calls “elective momentum”) or investors seeking to reduce tracking error (“forced momentum”). Retail investors are invariably attracted to hot stocks. Systematic traders, such as so-called commodity trading advisors and many hedge funds, are trend-followers. Selling an underperforming fund and putting the proceeds into a competitor with a superior recent track record constitutes momentum. Shifting from an active manager to an index fund has a similar effect.
There’s more momentum around today than ever. Active fund managers constitute around 10% of the turnover of the U.S. stock market, down from 80% three decades ago, according to CBOE Global Markets. Retail investors attracted by commission-free trading on smartphone apps, such as the one operated by Robinhood Markets, are dominant. Trillions of investment dollars have shifted from actively managed to passive vehicles in recent years.
When people are uncertain about the future, says Woolley, they follow the herd. Since the prospective returns from investments in artificial intelligence are unknowable, investors are inclined to chase recent outperformers. That explains why the exposure of hedge funds to high-flying semiconductor and hardware stocks has gone parabolic.
In the late 1990s, momentum was on a tear. Value managers who failed to keep up with their benchmarks suffered massive outflows. GMO’s asset allocation division, overseen by Grantham, lost around half its assets under management. History appears to be repeating itself.
In his most recent letter to investors Terry Smith, the CEO of Fundsmith, observes that momentum in the U.S. stock market is “at a 30 year high and more extreme than in late 1999 just before the Dotcom bubble burst. As active fund performance continues to worsen, people abandon it, producing a vicious feedback loop.”
The Fundsmith Equity Fund returned -2.9% in the first six months of the year, trailing the MSCI World Index by over 14 points in sterling terms. Many clients have had enough: The assets under management of its flagship fund declined from £28.9 billion in 2021 to £12.3 billion at the end of June.
Smith is responding to this disappointing performance by changing his approach. Whereas before the firm’s investment mantra was to buy good companies at the right price and do nothing else, Smith now says it “will take more account of momentum.” This change of direction pushed portfolio turnover above 50% in the first half of the year. Fundsmith has sold some underperforming positions, replacing them in part with beneficiaries of the ongoing AI investment boom, including Taiwanese chip giant TSMC 2330.TW, turbine supplier GE Vernova GEV.N and marketing platform AppLovin APP.O.
Woolley believes these moves are misguided. Nevertheless, Fundsmith provides a real-time demonstration of the mechanisms he and Vayanos describe. The firm’s investment process is now explicitly constrained by client flows.
While momentum has historically delivered positive returns, its performance is patchy. A 2017 paper by Rob Arnott and colleagues at Research Affiliates distinguishes between “early stage” and “late stage” momentum. Whereas the former has generally been profitable, the latter consistently underperformed. Investment firms that seek to reduce tracking error in today’s market are engaged in late-stage momentum.
Momentum reversals are fierce and unpredictable. The strategy does best during strong bull markets, but extraordinary gains are given up when bubbles burst. It’s no coincidence that the most severe momentum reversals occurred after 1929, 2000 and 2008.
Investors who capitulated to momentum in the late 1990s were sucked into the tech bubble at precisely the wrong moment. Benchmark-hugging investors later suffered massive losses. On the other hand, those who resisted the herd and held their ground were rewarded. Now is not the time to embrace momentum, forced or otherwise, but to switch it off.
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(Editing by Peter Thal Larsen; Production by Pranav Kiran)
((For previous columns by the author, Reuters customers can click on CHANCELLO/edward.chancellor.bv@gmail.com))