Factor Primer Series: Momentum
The Chicago Bears downed the Dallas Cowboys last week. After what looked to be a lost season several games ago, they are now riding the wave of winning momentum and clinging to the idea that the playoffs may still be within reach with more of the same recent, positive experience. Returning to our series on factor investing (What is a Factor?; Small-Cap; Value), we will take a closer look at the momentum factor as it applies not to sports, but to investing. Throughout this series, we have defined factors as a source of excess return that is sensible, persistent over long time periods, pervasive across markets, and cost-effective to capture.
What is the Momentum Factor?
The momentum factor is generally defined as the excess returns from stocks that have shown strong performance in the prior 6-, 9- or 12-month time frames. In lay terms, momentum stocks are stocks that are trending. The idea of trending stocks existed for a while, but until Jegadeesh and Titman published their seminal momentum paper in 19931, how to systematically capture momentum was unknown.
How Does the Momentum Factor Provide Excess Returns?
The outperformance of high momentum stocks can be explained in several ways. From a behavioral perspective, trending (or herding) could very well lead to increased returns. As a stock becomes more popular due to prior performance, more people decide to invest in this stock and its price is increased as a result of the increased demand for that stock. From a more financial perspective, high momentum stocks tend to exhibit stronger earnings growth in a 12-month time frame, which could also lead to higher returns2.
This outperformance can be substantial over time. As seen below, the stocks displaying the most momentum over time exhibit higher returns (over 16% annualized from January 1927 through October 2019 versus the market return of approximately 10%).
Like all good things, this outperformance does not come free. Momentum strategies require frequent rebalancing and trading, and as a result, can be costly to implement and highly tax-inefficient. Until very recently momentum was primarily used in hedge funds, though recent innovations have allowed the construction of momentum strategies in tax-efficient ETF wrappers.
Momentum in a Portfolio
Diversification is a coveted quality of any good portfolio. As with stock and bond diversification, factor diversification makes sense over time. Momentum is a powerful addition to a diversified factor portfolio, especially in the presence of value. Given that momentum and value often move in different directions, they work well together to provide outsized returns while dampening volatility. BDF uses momentum, in conjunction with 3 other factors (value, small-cap stocks and profitability) as a key part of its portfolio. Stay tuned next month, as we will dive into our last factor, profitability.
Chart source: Ken French Data Library. Momentum portfolios are constructed each month including NYSE, AMEX, and NASDAQ stocks with prior return data using the CRSP database. To be included in a portfolio for month t (formed at the end of month t-1), a stock must have a price for the end of month t-13 and a good return for t-2. In addition, any missing returns from t-12 to t-3 must be -99.0, CRSP’s code for a missing price. Each included stock also must have ME for the end of month t-1. The portfolios are broken down in deciles.
1] Narasimhan Jegadeesh; Sheridan Titman.” Returns to Buying Winners and Selling Losers: Implications for Stock Market Efficiency,” The Journal of Finance, Vol. 48, No. 1. (Mar. 1993), pp. 65-91
2] Jesse Livermore, Chris Meredith, CFA, and Patrick O’Shaughnessy, CFA “Factors from Scratch: A look back, and forward, at how, when, and why factors work,” May 2018, https://osam.com/Commentary/factors-from-scratch