Q&A with IFA: Momentum at the Asset Class Level

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Question: I understand that there is evidence that momentum is one contributing factor to long term performance (in addition to the size and value factors). There is a current advisory service (Fundx) that purports to capture the momentum factor and improve long term performance by scoring asset classes on recent relative performance utilizing a combination of 1, 3, 6, and 12 month returns. Is there any evidence that this approach works over the long term? Is it possible that using relative strength scores for asset classes and tactically allocating assets (within an overall portfolio strategy) based on recent relative strength of asset classes can improve performance over the long term?

Answer: Recall that momentum 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 past articles such as this one, we have discussed how momentum is indeed a factor that explains the variations in returns of diversified portfolios. While at first blush it appears to be of similar strength to the well-known size and value factors, it is problematic to capture in live portfolios due to the high turnover it requires. In this article, we showed how one company (which has been a thought leader in analyzing momentum) has had a difficult time capturing momentum in its mutual funds. Instead, those funds got the returns of growth indexes of similar size, which makes sense since a long-only momentum strategy will tend to concentrate in growth stocks. The funds managed by Dimensional Fund Advisors benefit from momentum by using it as a trading strategy overlay to delay both buying stocks with negative momentum and selling stocks with positive momentum.

Regarding momentum at the asset class level, we are only aware of this paper that appears to support the concept, at least for different types of futures contracts. We are also aware of three potential challenges to this paper. First, the paper was limited to the returns of 58 futures contracts over a 45-year period ending 12/31/2009. This is a small data set compared to what other papers used that examined momentum across the cross section of individual stock returns. Using limited data may cause the results to reflect random noise and makes it questionable as to whether investors can expect the results to persist. Second, the paper assumed monthly rebalancing which will result in high turnover. The full impact of trading costs, constraints on trading, and taxes do not appear to be reflected in the results. Finally, investors should have a sensible reason for why they would expect this particular strategy to work, and the paper proposes that momentum is caused by the poor behavior of other investors (i.e. performance-chasing). However, as our director of trading pointed out to us, “If your strategy relies on the stupidity of others, then you don’t have a strategy.” If behavioral biases lead to easy profits, asset prices should quickly adjust to eliminate their impact.

Regarding the performance of the six FundX mutual funds, we tested them against their Morningstar category-based benchmarks. As seen below, three of the six had negative average alpha while the remaining three had positive average alpha between 0.27% and 0.65%, which is nowhere near a statistically significant level. We note that two of the funds follow a pattern of five to six consecutive years of positive excess returns followed by seven years of negative excess returns, indicating the possibility of substantial style drift.

We at Index Fund Advisors conclude that our clients have profited from momentum in the funds that we advise for them to use, but we do not see a compelling reason to use momentum as either a tactical asset allocation strategy or as an overlay to our rebalancing strategy.