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Blog Posts — March 23, 2018

Evaluating the true cost of momentum investing

A recent report by Research Affiliates1 states that while momentum is one of the most compelling risk premia factors, there is a significant performance gap between theoretical and live results, with the latter proving considerably weaker.

Three major contributors to the lag in actual returns, the report finds, are high turnover costs, lack of sell discipline and loss of momentum.

Momentum has been an outstanding performer in the last few years, so it is no surprise that it continues to gain in popularity. The iSTOXX® Europe Momentum Factor Index, for example, has returned 85% in the past five years, compared with a 45% gain for the STOXX® Europe 600 Index.2

Only in January 2018, momentum-style exchange-traded funds (ETFs) and products (ETPs) attracted $1 billion globally, or 6.3% of total assets, according to ETFGI.

Momentum as a risk source

Momentum is one of six key sources of systematic risk and potential returns in the iSTOXX® Factor Indices. The indices, which were developed in collaboration with Hamburg-based investment boutique Alpha Centauri, also offer exposure to value, carry, size, low risk and quality, all of which can complement each other. For instance, momentum tends to outperform when value underperforms, and vice versa.3

Momentum investing relies on the premise that most stocks that have performed well can continue to outperform, and those that are doing badly are likely to keep disappointing. This phenomenon is probably best explained by behavioral finance theories that say that investors tend to hold on to ‘winners’ for longer than can be explained by fundamentals.

The iSTOXX Europe Momentum Factor Index and the iSTOXX® USA Momentum Factor Index rank stocks according to two criteria: those that have done the best in the past 12 months but have suffered limited reversal in the past month.

Limiting turnover in a world of fast information decay

Portfolios are constantly trading newly available information, but must do so bearing transaction costs in mind. Because today there is a high information decay – faster, real-time news becomes old news soon – the rate of turnover becomes a crucial component.

The iSTOXX Factor indices have a monthly turnover limit of 25% of their constituents’ value, a marginal point under which Alpha Centauri believes an investor can expect to have positive returns after transaction costs.

“You typically only trade if you think that the expected return from trading into new positions is much higher than justified by the transaction cost,” said Ulf Fuellgraf, managing director at Alpha Centauri.

The impact of trading costs in a momentum strategy was recently analyzed in a paper by members of the AQR Capital Management team,4 who concluded that costs would need to be more than five times higher than what was experienced with live trades between Jul. 2009 and Dec. 2016 to fully wipe out the average returns in momentum strategies.

Momentum portfolios in the AQR study generated gross average historical excess returns over the benchmark of 1%-1.5% per year. That compares with annualized overall trading costs of 0.23% of net asset value over the study period.

Other constraints the iSTOXX factor indices methodology include a limit in the number of stocks and a cap on each stock’s weight.

Methodology and optimization approach help trigger sell signal

A strict sell discipline is a function of the iSTOXX factor indices’ process. The indices aim for a high factor tilt, a proxy for a stock’s expected return. Constituents get a larger weighting the higher their expected return is based on the given factor. Additionally, a set of optimization constraints looks to limit unintended risks beyond the targeted factor. These constraints around country, sector and currency risk embedded in the methodology seek to provide a factor tilt as pure as possible, while being neutral around all other sources of risk.

“There is a direct link between information decay, tracking error, rebalancing frequency and turnover,” said Alpha Centauri’s Fuellgraf.

Loss of momentum

The factor index process, again, guards against any constituent’s loss of momentum. As the process is run monthly, stocks with weaker momentum scores are reduced or sold. The methodology ensures that the portfolio is made up of each month’s best-of-momentum stocks with all constraints considered.

Opportunities in 2018

Many investors say momentum will continue to perform well in 2018, although, like all factor premiums, it is subject to cyclicality and reversals. The BlackRock Investment Institute cites continued global economic expansion and a low-volatility regime as key drivers for momentum funds.5 BlackRock’s analysis shows the funds outperform broad indices in this environment.

With a strict systematic optimization process, momentum investing can provide significant excess returns. And when used in conjunction with other factor strategies, also offer true diversification.

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1 Arnott, Kalesnik, Kose and Wu, ‘Can Momentum Investing Be Saved?’ Research Affiliates, Oct. 2017.
2 Net-of-taxes total returns in euros, five years through Mar. 19, 2018.  
3 Asness, Moskowitz, and Pedersen (2013) in ‘Implementing Momentum: What have we learnt?’ by Israel, Moskowitz, Ross and Serban, Dec. 11, 2017.
4 Ross, Moskowitz, Israel and Serban, ‘Implementing Momentum: What Have We Learned?’ Dec. 1, 2017.
5 Moore and Shores, ‘Has momentum had its moment?’ BlackRock Investment Institute, Feb 2018.