momentum

Capturing the Momentum Factor—Simple but Not Easy

momentum

Last year, we wrote this article about momentum, which as the name suggests, is the tendency of securities that have outperformed (or underperformed) the market over a three- to twelve-month period to continue to outperform (or underperform) the market. In other words, momentum is the tendency of past winners to keep winning and past losers to keep losing relative to their peers. We noted that momentum is different from the risk factors of size and value in that it presents a far greater challenge to capture after incurring trading costs.

Dimensional Fund Advisors (DFA) chooses to take advantage of momentum by primarily using it as an indicator for when not to trade. As an extreme but illustrative example, a large cap stock that suddenly migrated into small cap territory would not be immediately purchased in a small cap fund, and a small cap stock that suddenly grew out of small cap territory would not be immediately sold.

One investment manager that attempts to directly exploit the momentum factor is AQR Capital Management which has $105 billion under management as of 3/31/2014. AQR has a very strong connection to the University of Chicago Booth School of Business.  Two of its three founding principals (Cliff Asness and John Liew) received their MBAs and PhDs from there, and AQR has endowed a chair that is currently occupied by Professor John H. Cochrane, an expert in asset pricing theory and the son-in-law of Eugene Fama. In his bio on AQR's Website, Asness humorously notes that as Eugene Fama’s student and teaching assistant for two years, “He still feels guilty when trying to beat the market.” We could go on about the people at AQR, but we will suffice it to say that they are heavy hitters in the world of finance and they are definitely worthy of our attention.

AQR has three momentum-based mutual funds that have over four years of returns data:

1) AQR Momentum Fund (AMOMX) which invests in large/mid U.S. companies

2) AQR Small Cap Momentum Fund (ASMOX) which invests in small-cap U.S. companies

3) AQR International Momentum Fund (AIMOX) which invests in large/mid international companies

It is important to note that these funds only attempt to capture the long side of momentum, so they do not short-sell stocks with negative momentum. All three funds are managed in order to “maintain flexibility to trade opportunistically in order to strike a balance between maintaining the desired exposure to positive momentum while attempting to keep transaction costs low.”1 While AQR states that these funds are expected to have turnover in excess of 100%, Morningstar has them pegged at 62%, 49%, and 76% for each of the funds in the order listed above.

Although these funds are benchmarked to Russell and MSCI indexes, AQR maintains three separate momentum indexes that are analogous to these funds. So far, these AQR internal indexes have had a higher correlation to the funds than the Russell and MSCI indexes. Furthermore, these indexes are also based on capturing the long side of momentum, but they do not account for the trading costs of the high turnover of maintaining a momentum strategy. Nevertheless, we felt it was worthwhile to see how well the funds have tracked these indexes in the 56 months of historical returns data that we have as of 3/31/2014. The table below summarizes the results.

For two of the three funds (ASMOX and AIMOX), the fund return lagged the index return by more than one percent, the bulk of which can be explained by the expense ratios of the funds at 0.65%. For the fund that beat its index by 1.5% (AMOMX), the explanation may lie in the negative impact of momentum itself during that time period. The table below shows how the AQR momentum-based index had a lower return than a growth index for US large/mid cap but a higher return for US small cap and international. For all three funds, the annualized returns were closer to the corresponding growth index than they were to the AQR momentum-based index, although the tracking errors to the latter were lower.

The reason for the comparison to growth indexes is that following a momentum strategy entails purchasing higher priced stocks which causes the portfolio to tilt towards growth. Morningstar classifies all three of those funds as growth funds. Interestingly, a recent paper2 whose authorship includes two AQR principals and a Chicago Booth professor found momentum to have a negative correlation with the value risk factor, meaning that a portfolio that incorporates both of them is likely to have higher risk-adjusted returns relative to the market. Unfortunately, capturing both simultaneously is not always feasible.

To summarize, it is still very early in the game to draw a conclusion as to whether or not the AQR momentum based mutual funds will successfully capture the momentum premium, or at least the long side of it. If they don't capture it, we highly doubt that anyone else will. Furthermore, the momentum premium itself going forward may not be high enough to make the effort worthwhile. Another recent paper3 found that found that the excess profits from momentum have become statistically insignificant since the late 1990’s, primarily due to extreme losses from periods such as March-May of 2009. We will continue to watch these funds and keep you apprised of our findings.

 

1https://www.aqrfunds.com/OurFunds/MomentumFunds/MomentumFund/Overview.aspx

2Asness, Clifford S., Moskowitz, Tobias J. and Pedersen, Lasse Heje, Value and Momentum Everywhere (June 1, 2012). Chicago Booth Research Paper No. 12-53. Available at SSRN: http://ssrn.com/abstract=2174501

3Bhattacharya, Debarati, Kumar, Raman and Sonaer, Gokhan, Momentum Loses its Momentum: Implications for Market Efficiency (November 7, 2012). Midwest Finance Association 2012 Annual Meetings Paper. Available at SSRN: http://ssrn.com/abstract=1928764