AQR’s Asness on Fama, Momentum Investing and More

Clifford Asness, Managing and Founding Principle of AQR, writes in his “Cliff’s Perspective” blog about Nobel Laureate and Professor Eugene Fama’s views on momentum investing. Asness is a believer in momentum and, as he notes, wrote a dissertation on it under the supervision of Fama. Asness notes that “the long-term success of the momentum factor seems to be a challenge to many observers,” including Fama. Commenting on a recent interview with Fama, Asness notes that the professor has said of momentum that he is “hoping it goes away” and that it is the “biggest embarrassment to the theory” that Fama is well-known for, the efficient markets hypothesis. While Asness expresses great respect and admiration for Fama, and notes that they would probably give very similar investment advice, the two clearly differ on the validity and utility of momentum investing. Asness says, “I’m still somewhat befuddled how one stops at a five-factor model [as Fama does] and doesn’t make momentum the sixth.” The two have debated the topic of momentum for over two decades.

Asness notes that, in the interview he references, Fama “mentions momentum’s turnover in two very different ways.” First by indicating “it’s more costly to trade” and, second, by suggesting that “the higher turnover of momentum makes it implausible that ‘risk’ can explain its high average returns.” (Fama is a leading thinker on value investing who, through his theory on efficient markets, has offered that higher returns come only from higher risk). Asness digs into the later point, noting that elsewhere in the interview, Fama refers to periodic crashes of the momentum strategy, stating “momentum tends to blow up every now and then,” which Asness interprets as “clearly implying momentum is very risky.” Asness comments: “If Professor Fama thinks that momentum is indeed quite scary it should be a joyful occurrence for his confidence in the factor” because “Professor Fama has been taking the ‘risk’ side (vs. behavioral inefficiency) of the debate regarding why the value factor works for more than three decades now.”

Asness’ own view, as reflected in the post, is that “a well-constructed value strategy diversifies momentum (and vice versa) so well that a combination strategy of the two is far better than either alone and not particularly crash-prone (that is, value, properly constructed using up-to-date prices, has done quite well during the momentum crashes making the total diversified result not extremely ‘crash-like’).” Further, he notes that “momentum crashes have largely occurred during steep market up-turns that reversed prior steep declines” and continues: “Risk isn’t just the chance of losing money, it’s about when you lose, and losing after the worst is over and during the rebound is not as ‘risky’ as losing in the bad times.” Finally, Asness offers that “momentum’s long-term success might be due to any combination of three reasons,” noting that “each could have degrees of truth and the relevance of each could vary through time.” It may simply be “data mining,” or “just luck.” Second, Asness notes that “momentum’s success could be rational compensation for risk.” Third, he suggests it “could be from some form of irrational behavior and investor biases showing up in prices,” which is the reason he thinks likely accounts for “the lion’s share of the real explanation for momentum’s success.” The “why” question related to momentum’s success aside, Asness concludes, “the debate as to its existence and whether it can be captured should be put to bed at this point.”