Momentum strategies are alive and well. Their resurrection in 2017 came not a moment too soon, as many financial advisers in recent years had been on the verge of declaring momentum to be dead. That’s because the approach, which historically had been one of the most profitable, had turned in a decade or more of mediocre returns (or worse).
Many wondered if momentum had become yet another casualty of an efficient market, in which once-profitable strategies stop working as more and more investors started to follow them.
The doubters were converted in 2017. Consider iShares Edge MSCI USA Momentum Factor ETF MTUM, -0.10% which gained 37.6% last year, nearly double the 21.8% return of the S&P 500 SPX, -0.06% . That was the reverse of what happened in 2016, in which this ETF lagged the S&P 500 by a wide margin (4.9% to 12%).
Momentum’s stellar 2017 performance also was consistent with a recent academic theory about the approach: It works best when the stock market’s volatility is low. That theory had been used by some to explain away the previous years of disappointing performance, since volatility in many of those years had been quite high.
But volatility in 2017 was at historical lows; it would have been particularly disheartening to momentum’s followers if the approach hadn’t staged a comeback. (Read a column I wrote a year ago on the academic research into the relationship between momentum and market volatility.)
You might still wonder if now is a good time to start following momentum strategies, since many worry that a bear market could begin soon. But there is no evidence to suggest that high-momentum stocks perform worse than the broad market as a bull market ends and a bear market begins, Tobias Moskowitz, a finance professor at Yale and a principal at AQR Capital Management, said in an interview.
On the contrary, high-momentum stocks may be one of the best strategies to follow in the late stages of a bull market. That’s because aging bull markets often suffer from ever-deteriorating breadth, in which fewer and fewer stocks are propelling the overall market higher. Momentum strategies are an obvious way of investing in the ever-smaller group of stocks that are leading the advance.
Even GMO’s Jeremy Grantham, who focuses on value and therefore generally eschews momentum, is telling clients that momentum strategies are “the best possible hedge against the underperformance you will suffer if invested in a sensible relative-value portfolio in the event of a melt-up.”
This discussion doesn’t mean that high-momentum stocks aren’t risky or won’t lose money in a bear market. My point is that such stocks’ above-average risk doesn’t manifest more at the beginning of a bear market any than at any other point in the market cycle.
Consider portfolio volatility, which is one proxy for risk. According to data available from the website maintained by Dartmouth finance professor Ken French, a portfolio invested in the 10% of stocks with the highest momentum has been 36% more volatile since 1927 than the stock market as a whole. (This calculation is based on calendar year returns.)
If high-momentum stocks’ above-average volatility is too much for your risk tolerance, you might consider the several risk-reduction strategies employed by one of the momentum-oriented investment newsletters I monitor — NoLoad Fund*X, edited by Janet Brown. The best performing of this service’s conservative momentum strategies calls for avoiding the most speculative stock funds, no matter how impressive their recent performance, and instead applying momentum just to funds in their “High Quality Growth Category.” A fund makes it into this category only if its historical riskiness is no greater than average.
A high-momentum portfolio in this High Quality Growth Category has beaten a buy-and-hold strategy since 1980 by an annualized margin of 14.1% to 11.5%, according to my performance monitoring, even while incurring slightly less volatility than the broad stock market.
An even more conservative momentum strategy that is also recommended by NoLoad Fund*X focuses only on just those funds in the “Total Return” category, which the service defines as those that are “Balanced”— invested “in a mix of stocks, preferreds, convertibles, bonds and cash.”
This more conservative momentum strategy has lagged a buy-and-hold approach by just 0.2 annualized percentage points since the mid-1980s, but in the process reduced volatility/risk by 26%. It’s a winning combination to come that close to matching the market’s return while reducing risk by that much; in a risk-adjusted basis, this high-momentum portfolio of Total Return funds is well ahead of the market.
The bottom line? Notwithstanding skeptics who in recent years wondered if momentum strategies had stopped working, the approach appears to be alive and well. And there’s no special reason to avoid the strategies just because you worry that a bear market could begin at any time.
For more information, including descriptions of the Hulbert Sentiment Indices, go to The Hulbert Financial Digest or email mark@hulbertratings.com .