Wes Gray of Alpha Architect is a frequent presence on Abnormal Returns. The last hear from him was talking about the efficacy of the value and momentum factors. Wes is also the co-author of three books: Quantitative Value, DIY Financial Advisor and the recently published Quantitative Momentum: A Practitioner’s Guide to Building a Momentum-Based Stock Selection System. I recently had a chance to ask Wes some questions about momentum, which at present seems to be a topic of much interest in the investment world. My questions appear in bold, Wes’ responses follow.
AR: How much weight do you put on the fact that momentum has been identified by writers for centuries?
WG: In our book Quantitative Momentum, we discussed Joseph de la Vega, who wrote about momentum effects he observed in the 17th century Amsterdam stock exchange. So, as you say, centuries ago people were observing that price changes can influence how future prices are set. We think de la Vega was on to something, so I put a lot of weight on this aspect of momentum because it suggests it is not an artifact of data-mining.
And today, hundreds of years later, we continue to piece together the momentum effect from an academic perspective. My old boss, Chris Geczy at Wharton and his coauthor Mikhail Samonov, assembled 200+ years of price-return data from the US stock market, and found strong evidence.
Momentum checks all the boxes when it comes to robustness. Some context: I’m a big fan of the, “Factor Investing Checklist,” outlined in Swedroe/Berkin’s new book, Your Complete Guide to Factor-Based Investing. Larry and Andrew laundry list the following requirements to assess the viability of a factor (discussed here in our book review):
- Be persistent over a long period of time, and across several market cycles;
- Be pervasive across a wide variety of investment universes, geographies, and sometimes asset classes;
- Be robust to various specifications;
- Have intuitive explanations grounded in strong risk and/or behavioural arguments, with reasonable barriers to arbitrage; and,
- Be implementable after accounting for market impacts and transaction costs.
Momentum is persistent (see our simulation study), pervasive (see Asness, Moskowitz, and Pedersen paper), robust (see various permutations in JT 1993), intuitive (lots of pain and arguably some systematic mispricing associated with underreaction), and implementable (tradeable, but constrained). Again, all these features taken together seem to indicate that momentum is very much a viable tool for investors.
Also, the fact momentum has been an open secret for many years suggests that there are real risks involved (e.g., more volatility!) and also real limits of arbitrage (e.g., requires superhuman discipline to exploit!). So one can expect, over the long-term, that the excess expected returns will continue. Why? Because it’s too difficult for people to stick with. So if investors want to engage in effective momentum investing, they need to size the position correctly and find a way to have the discipline to hold through thick and thin.
AR: Academic research has had little luck finding signal in the mass of technical analysis patterns and charts. However the research backing momentum is robust across time and markets. Is there any way to square this circle?
WG: Great question. First, there are some pretty wacky ideas that people pursue. So you have to separate the wheat from the chaff. Additionally, I think the premise that there is little evidence for technical analysis might be clouded by some element of bias inside the academic journals. After many years and a lot of new evidence, many academics are only now begrudgingly conceding that price-based signals can have predictive value. And there is still a lot of skepticism. Anything with the tag “technical analysis” immediately faces a high bar (perhaps unfairly). I do think this mentality might be changing, as the journals have become less and less controlled by the Efficient-Market-Hypothesis-Mafia. I imagine finance is no different than other academic fields and “science will advance one funeral at a time.”
For example, JFQA recently published, “A New Anomaly: The Cross-Sectional Profitability of Technical Analysis” and the JFE published, “Time Series Momentum.” Papers that would arguably never have been published 10 years ago. These papers are establishing the evidence for time series momentum related anomalies, which complement the cross-sectional momentum, or “relative strength,” anomalies already identified in the literature. Interestingly enough, time series momentum, often referred to as “trend-following,” is not a new idea, so the fact these ideas are finally getting published in academic journals hints that perhaps these concepts have been suppressed in the academic literature. Another interesting data point is Rob Stambaugh of Wharton — an incredible researcher and EMH mafia member for many years. Prof. Stambaugh has now taken a turn towards sentiment-based asset pricing and away from the EMH. See his recent co-authored paper with Yu Yuan, “Mispricing Factors,” as an example of this research (our review here).
On the flip side, and to justify the EMH-mafia bias against “technical analysis,” giving credence to technical analysis is dangerous because of the extreme danger of data-mining (see the Harvey Liu, and Zhu paper) and overfitting (see our review on Novy-Marx’s new paper). This undoubtedly contributes to the general disinclination in academia to embrace technical analysis. There are also few efforts from the theoretical asset pricing crowd to develop theories that credibly support technical analysis. Of course, if theoreticians won’t assume “irrational behavior” into their models, it becomes difficult to theoretically justify why prior price patterns would be able to reliably predict future returns. If it doesn’t match up with an EMH worldview, why go looking for explanations? But there are signs this too may be changing. For example, I think the idea of “slow moving capital” (see this piece and this piece as examples) is gaining credence in the academic community (even though the implicit assumption is that investors aren’t completely rational and suffer from limited attention). Perhaps these concepts will help researchers build models that predict why we see the technical patterns we see in the data.
AR: Does it give you pause that there is no definitive, or even plausible, explanation for why momentum works in so many different situations?
WG: Yes. But I think this is the case with all market phenomena — we can apply a scientific mindset to the problem to try and understand the world we live in, but it is unlikely we will ever actually know WTF is going on. The truth is out there, but we’ll never find it.
All that said, I think the Asness et al. quote from the article, “Facts, Fiction, and Momentum Investing,” summarizes my sentiment on momentum: “We discovered the world wasn’t flat before we understood and agreed why.” Just because we can’t explain the details of why momentum works, it does not follow that it is necessarily alchemy.
On the theoretical side, a core component of momentum’s excess performance is risk. You get paid higher returns because momentum is painful. But this clearly can’t explain the entire story. There has to be some element of systematic mispricing that is unable to be arbitraged away. My best working theory is momentum is an underreaction to the implicit positive news associated with trending price patterns. Eventually overreaction and herding probably play a role in adding gas to the momentum fire, but I don’t think they are the primary cause. I think the underreaction phenomenon is best described by Barberis et al. but I’ve floated another idea that it could be related to reflexivity. David Foulke has a nice post here describing how this might contribute to momentum. Basically, fundamentals don’t direct price over time, instead, prices might influence the fundamentals! Thus, they are “reflexive,” affecting each other in a feedback loop. And to the extent market participants can’t anticipate this second order effect that higher prices actually improve fundamentals, they’ll continually be “surprised” by stronger than expected fundamentals and researchers will continue to find momentum effects
There could also be fund flow effects going on.
Or maybe momentum is just the most epic data mining situation that has ever existed. We can never entirely rule that out, so we have to live with that doubt.
Bottom line: we’ll never know exactly why any of these things work. We can only try and seek the truth as best we can.
AR: Why don’t we see more investment products explicitly marrying the concepts of momentum and value?
WG: Since the long-only portfolios have low correlation, combining them seems to make sense. But many investors often have issues thinking at the portfolio level, and instead focus on each portfolio exposure in isolation (thus underappreciating portfolio pooling benefits). So perhaps it’s a bit on the obscure side of how people generally think about markets, but surely from a portfolio construction perspective it seems like a no-brainer. I’m not entirely sure why this isn’t more widely practiced and discussed — despite the fact firms like AQR (and our own) have been yelling at the top of their lungs about this idea for many years. That said, I’m perfectly content with the fact that not all investors take advantage of the portfolio benefits of pooling value and momentum strategies together.
Our best theory on why this isn’t more common was spelled out in a piece we wrote that suggests, “Evidence-based investing requires less religion and more reason.”
The article suggests that the world of investment ideas is almost like religion or politics — you’re on one team or the other — but you can’t be on both teams at the same time, and there’s very little room for conceptual overlap across dissonant ideas. So if you are a value investor, the idea of momentum disgusts you. Similarly, if you are a momentum/technical investor, the idea of value investing is horrid.
AR: One of the legitimate knocks on momentum investing is the issue of turnover. How does running a more concentrated strategy help (or hurt) this issue?
WG: Jack wrote a great piece on this subject here. Basically, momentum works best when it has high turnover and is more concentrated. What does that imply? Scalability issues. At a certain scale, a momentum portfolio must become overly diversified and/or turn over too infrequently to take advantage of the anomaly. Thus, not everyone can — or should — be a momentum investor. If too much disciplined capital (capital that holds no matter what) sticks with concentrated momentum strategies, over time the risk/mispricing premiums will grind lower. Of course, this makes a huge assumption: DISCIPLINED capital is involved. If the capital chasing momentum is flighty, short-sighted, and not willing to hold through thick and thin, capital chasing the momentum anomaly — even if it is a huge amount — will simply contribute to the vary anomaly they seek to exploit. In short, dumb money chasing smart ideas, means smart (disciplined) money will always have an edge.
AR: Given the power of trend, that you, Meb Faber and Gary Antonacci find, why bother with stock selection technique, like value and momentum, and just focus on trend-following strategies?
Trend seems to have legs in the context of market-timing (see here and here for our studies on this subject) and value and momentum seem to have legs when it comes to stock selection (see here and here for our work on this). So if you want to minimize your tail risk, trend-following seems like a reasonable approach. And if you want to generate outsized expected equity premiums, concentrated momentum strategies (and value strategies) fit the bill. In other words, you can effectively use them both, together, in combination. At least that is what I would consider the holistic view on the collective evidence currently available, as well as our own internal research which corroborates these findings. But smart people can disagree. I get it.
Now, that said, I also realize that there are various cheering sections that want to silo a particular idea into the “best” category. For example, someone might claim that trend-following ideas are the best and stock selection stinks (e.g., frictional costs are too high, data-mined, etc.). You also have cheerleaders that say stock selection is amazing, but trend-following is for wackos who enjoy whipsaws, paying taxes, and these cheerleaders will continue to worship the buy-and-hold Gods.
I personally think those seeking the “best” idea end up getting the wrong answer. The correct answer regarding whether stock selection is the “best” or “trend-following” is the “best” is simple: Yes. They both work. And they work great as a team. In fact, Jack wrote a post that directly shows that trend-following and stock-selection momentum should be considered friends, not enemies. So we think trend and stock-selection, working in tandem, can make a lot of sense. This is particularly true if one’s goal is to capture 1) an outsized expected equity premium, and 2) avoid massive tail risk events.
Here’s how it works:
- Leverage trend-following to avoid large drawdowns associated with market risk
- Leverage value & momentum stock selection to generate high expected equity premiums
If an investor throws value investing in the mix, an investor can exploit three big factors, simultaneously: trend-factor, value-factor, and momentum-factor. We talk about two versions of these concepts here and here. Plus, you get the added diversification benefits of putting value and momentum together, which I alluded to earlier. I highly recommend to investors looking for ideas on how to build portfolio constructs that take advantage of both trend-following and stock selection.
AR: Any final thoughts on momentum as a stock selection strategy?
WG: I’ll paraphrase a bit from our book, Quantitative Momentum here.
Momentum is the epitome of a simple strategy even your grandmother would understand—buy winners. And momentum is an open secret as I mentioned previously. The track record of the strategy is undeniable across time and asset classes.
So why isn’t everyone a momentum investor?
We believe there are two reasons:
- Hard-wired behavioral biases cause many investors to be anti-momentum traders (sell winners and hold on to losers),
- For the professional, who wants to exploit momentum, marketplace constraints make this a challenging enterprise: the career risk concerns are too great when a strategy can suffer poor relative performance over an extended time period.
If we follow this line of reasoning, we only need to assume the following to believe that a momentum strategy, or really any anomaly strategy, can be sustainable in the future:
- Investors will continue to suffer behavioral bias.
- Fund managers will be focused on short-term relative performance, which will continue to be driven by their short-sighted performance chasing investors.
We think we can rely on these two assumptions for the foreseeable future. And because of our faith in these assumptions, we believe there will always be opportunities for process-driven, long-term focused, disciplined investors to exploit momentum.