Momentum: A Fourth Factor

Momentum: A Fourth Factor

Momentum: A Fourth Factor

Throughout IFA’s Website, you will find references to the three-factor model formulated by Professors Eugene Fama and Ken French, which says that the expected return of a broadly diversified stock portfolio in excess of a risk-free rate is a function of that portfolio’s sensitivity or exposure to three common risk factors: (1) a market factor, as measured by the excess return of a broad equity market portfolio relative to a risk-free rate; (2) a size factor, as measured by the difference between the returns of a portfolio of small stocks and the returns of a portfolio of large stocks; and (3) a value factor, as measured by the difference between the returns of a portfolio of high book-to-market (or value) stocks and the returns of a portfolio of low book-to-market (or growth) stocks. The underlying premise of this model is that small cap and value stocks are riskier than large cap and growth stocks and thus carry higher expected returns.

For a diversified portfolio of domestic equities, the Fama/French three-factor model has been found to explain about 96% of the variation of returns. This, however, does not mean that a passive fund manager should robotically buy the securities that meet the fund’s parameters and sell the securities that no longer meet the parameters. Narasimhan Jegadeesh and Sheridan Titman1 introduced the factor known as momentum, 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. Eugene Fama referred to momentum as the biggest challenge to his theory of financial market efficiency,2 which implies that past prices of securities are irrelevant in the determination of future prices. Unlike the other three factors, momentum has no adequate risk-based explanation, but there is a possible behavioral explanation of underreaction to new information. Fama and French found that momentum is present in all the major international markets except for Japan.3

Since a security that is identified as having positive or negative momentum usually only retains it for a few months, directly trading to capture the momentum premium may not be a viable strategy because the cost of trading is likely to exceed the intended benefit. Further adding to the trading costs is the potential requirement to not only buy positive momentum securities but to short securities with negative momentum, and short-selling is expensive. Lastly, momentum does behave like a risk factor, meaning that in some time periods, following a momentum-driven strategy (even without trading costs) will produce a negative return relative to the market. A sobering example4 is the March through May period of 2009 when the lowest decile (past losers) rose by 156%, while the highest decile (past winners) gained only 6.5%. A would-be momentum trader who was short on the former and long on the latter would have been completely wiped out. A recent paper5 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.

As a highly successful passive fund manager, the primary way that DFA takes advantage of momentum is by not placing a trade when the momentum computation would argue against it. For example, suppose a large cap growth company runs into problems and takes a substantial hit on its share price to the point where it now meets the definition of a small cap (or value) company. Dimensional Fund Advisors (DFA) will not immediately buy those shares in their small cap and value funds because of the desire to avoid negative momentum. In the case of a company on its way to bankruptcy (e.g., Enron in 2001), this strategy may protect DFA’s fundholders. As a second example, suppose a small cap company currently owned in a DFA small cap fund hits the big time and is now classified as a large cap company. DFA will not immediately sell those shares even though technically the fund should not own that stock because it would now have positive momentum, so the best course of action (the one with the highest probability of success) is to wait a few months and then sell it.

One recent and highly interesting paper6  on momentum addresses its 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, it is not possible to maximize both of them simultaneosly.

As an investment fiduciary, IFA will continue to keep abreast of developments in finance to ensure that our clients have the best possible investment experience that we can provide. If you have any questions on momentum or any other investment-related topic, please feel free to drop us a line at [email protected].

 


1Narasimhan Jegadeesh and Sheridan Titman, “Returns to Buying Winners and Selling Losers: Implications for Stock Market Efficiency,” Journal of Finance 48 (1993): 65-91.

2Interview with Eugene Fama, Federal Reserve Bank of Minneapolis, Dec. 2007.

3Fama, Eugene F. and French, Kenneth R., Size, Value, and Momentum in International Stock Returns (June 21, 2011). Fama-Miller Working Paper; Tuck School of Business Working Paper No. 2011-85; Chicago Booth Research Paper No. 11-10. Available at SSRN: http://ssrn.com/abstract=1720139

4Kent Daniel and Tobias Moskowitz, “Momentum Crashes,” (http://www.columbia.edu/~kd2371/papers/unpublished/mom4.pdf)

5Bhattacharya, 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

6Asness, 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