Is momentum investing dead? Or is it just painful?

Is momentum investing dead? Or is it just painful?

September 7, 2016 Momentum Investing Research
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(Last Updated On: September 7, 2016)

Sometimes even the best evidence-based active investment strategies can create a formidable challenge to investors seeking to exploit them.

Case in point — momentum investing. 

On the one hand, stock-selection momentum strategies (here is a link to more information) can have the potential to generate excess expected returns over the long run; on the other hand, these strategies sometimes generate massive amounts of investor pain when they inevitably go through long bouts of poor relative performance. It’s a kind of quid pro quo: in order to access the potential gain, you must willing to accept the potential pain.

pain

But how much momentum pain can one expect?

Among the academic anomalies, the momentum effect suffers bouts of horrific underperformance (i.e., “crashes”) that are legendary among academics and practitioners alike. The relative underperformance is even worse than those associated with deep value strategies. But relative “underperformance” is an abstract term. Just how bad can the “pain and anguish” associated with momentum actually get?

In a remarkable paper recently published in the FAJ, “Two Centuries of Price-Return Momentum,” by Chris Geczy and Mikhail Samonov, the authors examine an extremely long time series to see just how painful things have gotten in the past for momentum investors. (Here is an older version: 212 Years of Price Momentum (The World’s Longest Backtest: 1801–2012). The paper conducts an incredible “out of sample” backtest on the so-called cross-sectional momentum phenomenon, which is traditionally measured via a L/S stock portfolio that goes long winners and short losers.

10 years of underperformance. Are you prepared?

First, let’s look at the cumulative returns associated with the excess return performance of winners and losers. Of course, this chart shouts the question: “Why isn’t everyone doing this?”

momentum over time
The results are hypothetical results and are NOT an indicator of future results and do NOT represent returns that any investor actually attained. Indexes are unmanaged, do not reflect management or trading fees, and one cannot invest directly in an index. Additional information regarding the construction of these results is available upon request.

If you’ve read this blog enough you already know the answer as to why everyone else isn’t doing this…IT SUCKS. But let me qualify that statement. It sucks to actually own this portfolio in a world where relative performance inflicts pain and we invest on a time scale that is day-to-day, week-to-week, and month-to-month. The long-horizon chart above doesn’t highlight the actual short-term pain associated with sticking to a strategy that lags the broad index for multiple years. The general term for this phenomenon is “time dilation” and Ben Carlson has a nice piece on it. Here is another interesting piece if you want to geek out a bit.

So is momentum investing dead?

We hear a lot of investors talking about the death of various active strategies because they must have “stopped working.” And while it is possible that a strategy can stop working, there is a certain irony to these claims — they can actually reinforce why a strategy will be sustainable in the future. We discuss this odd reality in our sustainable active investing framework.

Prior to 2009, the only major long-term loser period for a long/short momentum strategy was during the Great Depression era, when the strategy had 10 years of compounded negative returns (and boy was it ugly!). The chart below shows 10-year rolling returns for a long/short momentum strategy, and demonstrates how painful it would have been to be a momentum investor in those days:

momentum loser
The results are hypothetical results and are NOT an indicator of future results and do NOT represent returns that any investor actually attained. Indexes are unmanaged, do not reflect management or trading fees, and one cannot invest directly in an index. Additional information regarding the construction of these results is available upon request.

Ouch! That was a painful time to be a momentum investor. Yet, a decade of underperformance is not especially rare for momentum — as this paper highlights, it is actually pretty common.

Note that in three separate decades (ending 1890, 1900, and 1920) long/short momentum portfolios generated negative returns.

The last decade has also been rough for long/short momentum. From January 2002 to December 2012, the annualized spread between long and short portfolios was -2.1%. The chart below shows how 10-year rolling spreads collapsed in recent years (and went negative by 12/2012) and breaks the results out by the long leg and the short leg of the portfolio. Similar to episodes of L/S underperformance in the past, momentum pain is caused when buying winners stinks and buying losers turns out to be a winners game!

winner and loser
The results are hypothetical results and are NOT an indicator of future results and do NOT represent returns that any investor actually attained. Indexes are unmanaged, do not reflect management or trading fees, and one cannot invest directly in an index. Additional information regarding the construction of these results is available upon request.

The figure above also highlights that a long-only momentum investor (blue line in the “figure 2” above) will also have to suffer periods of long underperformance to reap the benefits of momentum. There are are multiple periods of 10-year relative underperformance for a long-only momentum investor. That really stinks, but for those with the discipline to stick with the program, they were rewarded with compound annual growth rates that would put an investor in very rare company.

Momentum probably isn’t dead, but momentum investing IS painful

Saying that cross-sectional momentum — the undisputed king of market anomalies identified by academic researchers — is “dead,” based on the fact the strategy has underperformed over the past 5-10 years, is akin to saying to that Michael Phelps is a terrible swimmer because he didn’t win an olympic medal in one of his races. Momentum is the research-consensus champion when it comes to the stock anomaly race, but that doesn’t mean it wins the race all of the time. In fact, momentum has historically gotten its face ripped off many times over relative to the passive buy and hold market. But horrific relative pain is something to be expected for robust “open secret” anomalies. Trying to arbitrage long duration anomalies like momentum requires a discipline and dedication that are extraordinary and uncommon and therefore, we can expect that these strategies will be successful in the future (at least relative to strategies that currently have Sharpe ratios of 3+ and never lose). In contrast, if a strategy mints money every day relative to the market and never creates pain, there can never be a sustainable gain. These “too good to be true” situations lead to rich proprietary trading groups, Madoff scams, hidden tail risks, and hyper-active portfolio transitions — none of these outcomes are positive for the long-term taxable investor that doesn’t run a super-computer filled room with math and physics PhDs trading their own capital.

But we’ll leave the last words to the authors:

The most recent underperformance [of momentum] raised practical questions about the “anomalous outlier” assumption and what the actual distribution of momentum profits is, which by their nature have influenced and will continue to influence theory about this powerful characteristic in returns. By extending our analysis of equity momentum returns to 1801, we have created a more complete picture of the potential outcomes of momentum strategy returns. In doing so, we discovered seven additional decade-long negative periods before the Great Depression.

Bottom line: Historical profits associated with momentum are real and anyone denying this fact may want to reconsider the broad body of research on the topic. However, on the flip side, those who claim that momentum is “easy” are denying the reality that active momentum investing is quite possibly the most painful anomaly to exploit. (not to mention the scalability might be limited, but this is another debate).


Editor note: one can replace “momentum” with “value” throughout the post without loss of integrity.


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Definitions of common statistics used in our analysis are available here (towards the bottom)




About the Author

Wesley R. Gray, Ph.D.

After serving as a Captain in the United States Marine Corps, Dr. Gray received a PhD, and was a finance professor at Drexel University. Dr. Gray’s interest in entrepreneurship and behavioral finance led him to found Alpha Architect. Dr. Gray has published three books: EMBEDDED: A Marine Corps Adviser Inside the Iraqi Army, QUANTITATIVE VALUE: A Practitioner’s Guide to Automating Intelligent Investment and Eliminating Behavioral Errors, and DIY FINANCIAL ADVISOR: A Simple Solution to Build and Protect Your Wealth. His numerous published works has been highlighted on CBNC, CNN, NPR, Motley Fool, WSJ Market Watch, CFA Institute, Institutional Investor, and CBS News. Dr. Gray earned an MBA and a PhD in finance from the University of Chicago and graduated magna cum laude with a BS from The Wharton School of the University of Pennsylvania.


  • Eau de Javelina

    Which brings us to the next question. Have there been extended periods of time in the past when both value and momentum underperformed at the same time? The refrain I typically hear is that they are somewhat uncorrelated and fit nicely together. That has not been true in the past few years. Has this happened before?

  • Both strategies can underperform when general market volatility is low – where trends move in a choppy sideways manner. First you need to determine how often you want to take a performance reading – every month, six months, one year, etc. To point out the importance of this, say you take a reading every minute; you’re going to see many one-minute intervals where both strategies are negative. On the other end of the spectrum, if you take a reading every hundred years, you likely won’t see many (or any) intervals with negative performance.

    Let me know what kind of time intervals you’d like to use to measure performance.

  • W.J. Keller

    Relative momentum (long/short) on stocks has indeed heavy drawdowns, even worse than the stock market itself. But an other form of (absolute) momentum, long-only asset-class trendfollowing, just has lower drawdowns than the index. So please distinguish long versus short, relative versus absolute momentum, and stocks versus asset classes.

  • GM

    Hi Michael,

    I had the same question as Eau. As for time frames looking at 3, 6 and 12 month performance of value and momentum would be great.

    PS sorry for jumping in Eau – your question is a great one and I’d love to know the answer so as to set my expectations and develop the necessary emotional fortitude to deal with a portfolio than may be failing from all angles.

  • Hannibal Smith

    Didn’t you point out in another article that the reason it SUCKS is because of being short the losers when the market bottoms?

  • yep, long/short momentum is great, but hazardous to your mental health.
    But even long-only can suck relative wind for a long time.

  • GRIMWEASEL

    Wes, Clenow in his book ‘Stocks on the Move’ recommends never shorting stocks as the math doesn’t work over the long time. I know a few L/S guys who just use an index ETF/fund for the short leg as downside protection, but it seems shorting individual stocks can be dangerous. Would long only be best for momo?

  • Clenow is bright and a friend. I agree with his approach and it is the same approach we follow. Stick long only on mom and hedge beta with futures/etf as required. Shorting the poor mom stocks could work to add a really unique return stream, but there aren’t many that can do it well after costs/brain-damage. AQR might be an exception.

  • This piece is in reference to the academic construct of momentum, which is typically stock selection momentum (relative strength, or “cross-sectional” momentum). Although, I’d argue that other forms of sustainable momentum also go through serious relative pain trains at times (ie trend you can be flat while the market zooms or whipsaws you).

  • GRIMWEASEL

    Ahh thanks Wes. You are in great company with Andreas it seems, Meb too. I love the approach in Clenow’s book, but the transaction costs in the UK are the killer, esp when markets start to whipsaw around the trend filter (100ema). He recommends only implementing with a portfolio >$1M. I had some TWTR discourse with him and he said the weekly re balancing could be pushed out to monthly or even quarterly and not change the return that much. His use of ATR for position size was also insightful. I just need to work for a century for the $1M in order to successfully implement now!

    One can get ‘some’ success in shorting stocks using the ISM PMI/NMI text to find industries in contraction and then short the worst stock (lowest PE) in that worst sector. The risk is when the value players ride back into town and bid your short into its stop! Plus, it’s a short term strategy not for the weak of pulse. Index and ETF hedges make more sense long term.