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Factor-based investing cheat sheets #1: Momentum

 

We take a look at what makes the fastest factor tick...

To say that factor-based investing or ‘smart beta’, has gathered significant attention and investment is an understatement. Although factors have existed for some time, I thought it was worth taking a quick breath to evaluate where each factor is today and whether or not we have learned anything since the seemingly unstoppable rise of these investment strategies. Recent shakes notwithstanding, given the long-term bull market run, and the rapid expansion in the factor landscape, what better place to start than momentum?

Let’s get the niceties out of the way with a quick synopsis of the factor’s characteristics…

 What is it? This factor intends to hold high momentum stocks in the hope of capturing what has historically been deemed risk premia.

 How do we calculate it? Standard practice uses 12-month returns, excluding the last month’s returns (sometimes two months), with various tweaks depending on investor preference. Generally, momentum strategies look to capture things that have trended up!

 Who gets credit for the discovery? Carhart in 1997, with some support from Fama and French later on.

 Why does it exist? Behavioural economics! People like winners and following the herd. What goes up can go up some more. More on this later…

 A common misconception is… that momentum is like cap-weighted market indices. See the performance and rolling correlation charts below, which dispel this myth.

 And another thing: This feels like the antithesis of value. Technically price movement is the only input into its construction and it does independently describe security price returns in addition to value, hence its status as a standalone factor. However, in the long-only portfolio space, value has historically tended to underperform when momentum outperforms, and vice versa.

 

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