September 22, 2009
Will it work in the future?
Momentum has worked in the past, and investors would have been better off with a combination of value and momentum than with a combination of value and growth (even after trading costs and taxes). That much is certain, but can one expect similar outperformance in the future?
Asness claims that his out-of-sample results, showing that momentum has worked across asset classes and markets, are strong evidence that momentum’s superiority will persist. His other out-of-sample test over time is that it worked during the 20 years since his initial research – but, of course, we must wait another 20 years to see whether the future will replicate the past.
Momentum has fared poorly in 2009, as value has been a clear winner. Asness’ explanation was simply that momentum, or any style, does not win all the time. In fact, momentum wins about two out of three years (an impressive result), but it does not work every time. That’s why you should make it only part of your portfolio, importantly combining it with value.
Also, there is some evidence that momentum has a tough time when the market abruptly turns around. This makes sense, since momentum bases its stock selection on rolling prior-year returns. Hence, abrupt movements in the market will only slowly be taken into account in a momentum strategy. Again, this is another reason why Asness recommends momentum be held as a complement to value, which often does well at such times.
There do not seem to be strong trends in momentum itself. Whether it’s done poorly or well, it seems to have the same better-than-even chance of doing well going forward.
A crucial issue, which was raised during the question and answer period, concerns Asness’ choice of a 12-month timeframe for his calculations. He presented the data below showing that if radically different time intervals were chosen, the results would be clearly inferior:
He stated that if you used one month instead of 12 months, you would “lose a ton of money.” But small changes in time interval, say using six months or 18 months, have a small effect on the results, indicating to Asness that the momentum effect is reasonably “robust.”
Similarly, the choice of the one month “lag” before selecting the stocks for the index is a critical assumption.
One possibility is that the popularity of social networks and the increased speed of communication will move Asness’ “sweet spot” away from 12 months with a one-month lag. Asness argued, however, that his timeframe has been robust in the face of rapid technology changes over the last 80 years. “Why it would change going forward if it hasn’t yet is a mystery,” he said. In any case, investors must embrace these critical assumptions if they become momentum proponents.
Investors should be concerned about turnover and taxes, and Asness is obviously sensitive to those issues, as well as the need to offer funds with very low costs. Momentum is clearly better-suited for non-taxable accounts.
Momentum is real and will persist into the future. The question is whether Asness can capture enough of it to make it worthwhile for investors.
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