By Jack Forehand (@practicalquant) —
Investors sometimes want to pigeonhole investing factors. We want to look at a factor and associate a certain type of company with it. Doing so makes us more comfortable with the factor and makes us believe we have a better feel for the types of stocks we will get if we invest using it.
With factors like value, this can be a somewhat productive exercise because the stocks that show up in value screens all share the common thread that they trade at a discount based on some sort of measure of their value. Value stocks also tend to come from a similar subset of industries. That gives investors a comfort level that they know what they are getting when they invest in value.
Momentum is an entirely different animal, though. Investors tend to associate momentum with growth stocks. If you try to name a typical momentum stock off the top of your head, you will probably think of names like Google or Facebook or Amazon. And that is especially true when we have gone through a growth dominated period like we have in the past decade.
But the reality is that momentum and growth are very different from each other. And that is a good thing for investors because momentum has generated an excess return over the market over time, while growth has not.
The reality is that momentum can be anything. It can sometimes be value. Other times it is growth. It can invest in low quality companies and then pivot and buy high quality ones. It can invest in low volatility stocks, or the high beta stocks at the complete opposite end of the spectrum.
As Corey Hoffstein from Newfound Research put it in a podcast interview a while back, momentum is a chameleon. It doesn’t care how well a business is doing. It doesn’t care if it a cheap. All it cares about is that the stock price has gone up.
The Misconception About Momentum and Growth
Even during long-term periods where one investing style dominates like we have seen with growth during the past decade, momentum will still pivot back and forth as market leadership temporarily changes.
So even though many investors associate momentum with the FAANG stocks in the past decade, the reality is that a momentum portfolio would have not held them far more than it would have.
Let’s say I ran I hypothetical portfolio that was rebalanced monthly and held the top 10% of stocks in our investable universe (approximately 270 stocks out of 2700) using 12-1 momentum, starting at the 2009 market bottom. The table below shows how often that portfolio would have held the FAANG stocks over that period.
| FB | 14.3% |
| NFLX | 44.1% |
| AMZN | 21.0% |
| AAPL | 16.1% |
| GOOGL | 3.6% |
Despite the massive returns of these stocks, this hypothetical momentum portfolio held all of them less than 50% of the time and barely held some of them at all.
Why is that? There are two reasons. First, there are a lot of stocks out there, so even though these stocks performed well over the period, there were other stocks that were performing better at any given time. Second, momentum works best when measured over intermediate term periods, so just because a group of stocks have long term momentum doesn’t mean they regularly exhibited intermediate term momentum throughout the period.
Momentum and the Other Major Investing Factors
Ok, so we have established that momentum is very different from growth. But if it isn’t growth, what types of stocks does it involve buying?
Another way to look at the changing nature of momentum is to look at its relationship to the other factors over time. Because momentum doesn’t care about why a stock is going up, it will be aligned with different factors as market leadership changes.
As an example, here is a look at what the top decile of momentum stocks in our database looked like using our factor scores at the market bottom in March 2020 vs. what it looks like today (scores range from 1 to 99 and higher scores indicate more exposure to the factor).
| 3/26/2020 | 3/26/2021 | |
| Value | 29 | 35 |
| Quality | 40 | 34 |
| Low Volatility | 40 | 22 |
What you see in the results is exactly what we would expect based on what has happened in the past year. The hypothetical momentum portfolio has been adding exposure to value stocks and low-quality stocks (which have performed well) and reducing exposure to low volatility stocks (which have performed poorly). If the trends in the market continue, these changes will continue to increase over time and we will likely see momentum strategies continuing to add value exposure when they reach their rebalancing dates. If you look at past periods where market leadership changed, you will see the same thing.
The Challenge of Understanding Momentum
Momentum is without question one of the most robust investing factors. It is hard to argue with the long-term data that supports its effectiveness. But if you are going to follow a momentum strategy, it is important to become comfortable with the fact that the types of stocks you will get will vary significantly over time. In the end, as Corey Hoffstein said, momentum is a chameleon. Understanding that fact is key to successfully implementing it as an investment strategy.
Jack Forehand is Co-Founder and President at Validea Capital. He is also a partner at Validea.com and co-authored “The Guru Investor: How to Beat the Market Using History’s Best Investment Strategies”. Jack holds the Chartered Financial Analyst designation from the CFA Institute. Follow him on Twitter at @practicalquant.
