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Excess Returns
The Market's Best-Kept Secret | Travis Prentice on Momentum's Surprising Edge
00:50:44
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- [00:00]
A
It doesn't matter what you think. It really matters what the market thinks. Momentum isn't static right there. If Nvidia had momentum, it doesn't mean it always will always have momentum. So the thing about momentum is it's going to always reorient to what's working, what's trending. So it doesn't care, you know, what the valuation is or what if it's in the value category or defensive category. It just cares about what's outperforming. The highest expression of momentum is price reflecting something and not just price. A momentum strategy is actually much more tax efficient than most people think. In fact, it looks as about tax efficient over the long term as a value strategy. If you look at the top 15 worst months for momentum, it's not necessarily those winners being sold. It's the loser side of your portfolio that you don't own that crashes upwards.
- [00:51]
B
Travis, thank you very much for joining us on Excess Returns.
- [00:55]
A
Yeah, thanks for having me. Big fan of the show.
- [00:57]
B
That's awesome. Thank you. So we want to have you on to talk all things momentum investing, what momentum investing is, how you define it, how you guys use it at the informed momentum company to build investment strategies. Probably talk about some of the obviously good qualities of momentum, but maybe some of the things that investors kind of got to be paying attention to when they're looking to deploy momentum sort of in their investment methodology. So, you know, this is going to be fun and exciting and yeah, we'll. We'll kick it off with. I think you and Jack were, you know, recently got together in person. So, Jack, I'll let you kind of take the lead on this first one because I know it kind of relates to the conversation you guys were having.
- [01:39]
C
Yeah.
- [01:40]
B
Something that came up at our launch.
- [01:41]
C
I thought was a great way to start, to start this discussion because whenever we're talking to investors about momentum, like, one of the questions we always get is about Nvidia. And maybe not as much true now because Nvidia struck a little bit this year. But if you think about the decade before that, people would look at our momentum portfolios and they'd scan them and they'd be like, well, where's Nvidia? And a lot of the time Nvidia is not there. And they're like, well, how could it be a momentum portfolio not have Nvidia? And I think if that gets at so many of the things about momentum that people need to understand that Nvidia is not. Or companies like that that have done really well over Long periods of time are not necessarily always going to be in your momentum portfolio. So I want to start by asking you that question, like, why would Nvidia not regularly be in a momentum portfolio when it's having this huge massive 10 year run?
- [02:23]
A
Yeah, absolutely. And you get, you get at the heart of the matter, which is how do you define momentum and how do you implement momentum. But I think one of the things that people don't understand is momentum isn't static. If Nvidia had momentum, it doesn't mean will always have momentum. So the one thing about momentum is that it's always changing, it's always adapting. So that momentum portfolio that may have had very strong momentum six months ago may be very different now. So yeah, it gets at the heart of the matter with momentum investing. You know, how do you define it and how do you implement it? All those decisions make a, a huge difference in terms of not only outcomes, but what makes it into a momentum portfolio.
- [03:00]
B
And I think too like, you know, while Nvidia may have had like great performance, like there's hundreds or thousands of other stocks that are also performing well. So you know, once you get outside like the mega cap universe, you know, you might have better scoring momentum stocks that actually are exhibiting more momentum than something like Nvidia, which everyone knows about.
- [03:21]
A
Yeah, totally. It's when we talk about momentum, we're talking about obviously a cross sectional momentum or relative strength. So it's always the top performing stocks, whether it be over the last 12 months, six months, what have you compared to a universe, a selection universe. So yeah, there is sometimes, depending on your selection universe, intense competition to be in that top decile or top quintile momentum portfolio. So yeah, it totally depends on the timeframe and, and what selection universe you're using.
- [03:49]
B
Can you just like shake that out a little bit more for our audience? So cross sectional or relative strength, like how would you explain that to someone that is kind of familiar with momentum investing? They know it's like buying winners, but like kind of more, more with more detail. How would you explain that to someone?
- [04:07]
A
Yeah, sure. It's just the relative performance of a security versus its peers. So the most common way would probably be by country or by market cap. So if you're selecting out of a small cap universe in the US maybe you're using Russell 2000 as your selection universe. So roughly 2000 companies and you're looking at the relative price performance. So the winners, what's winning? And the standard definition of momentum is what's called a 12 minus one. So the last 12 months of performance, but you delete the last month because there tends to be a reversion. We can get into all those details later. But generally it's always the price performance over 12 months relative to its peers by country or market cap and generally either taking the top decile of relative performers. So the top 10% of companies that have performed the best. And a lot of research, not only ours but in academia, suggests that those companies that have won or have outperformed continue to outperform for a period of time.
- [05:06]
B
Yeah, Many investors kind of think that momentum investing is the same thing as like growth investing. And oftentimes some of those growth companies do get in those high relative strength or high momentum portfolios, but that's not always the case. So can you just explain why that is?
- [05:24]
A
Yeah, definitely. There is some very large misconceptions when it comes to momentum investing. And you hit on one of the main ones, which is it tends to get confused with momentum is the same thing as growth. And there's some reason for that because if you look at long term excess return correlations, momentum and growth actually have a positive correlation on average over the long term. However, if you look at that behavior, there's a lot of volatility or variance around the mean. So there's times when momentum is, is growth and there's very. And there's times where it's very much not. And it turns out when momentum is not growth, which makes all the difference in terms of its excess return premium. So the thing about momentum is it's going to always reorient to what's working, what's trending. It's kind of irrespective of style boxes. So it doesn't care, you know, what the valuation is or what if it's in the value category or defensive category. It just cares about what's outperforming. So it's going to reorient or rebalance towards trend and away from weakness, whereas growth is going to rebalance to what has grown or what's projected to grow. But all too often that also means just rotating to expensive stocks, which is why the premium isn't as strong over the long term.
- [06:35]
B
You know, it's, it's kind of funny. I remember, I think it was last year, although maybe you guys will correct me and made my timings wrong, where there was a big and I don't know what momentum fund it was. I thought it was one of the S and P, some momentum ETF that was rebalancing like right around maybe the first quarter and it was like going heavy in energy. And that was kind of like that. You know, on Twitter and you know, even in other places of cnbc, they were talking about it because it was such a big rebalance and it was billions in assets. But it was going from like sort of heavy tech growthy to like heavy energy because energy, I think had, had bounced back. So to, to your point that, you know, momentum can bring you to completely other areas of the market that you might not think a portfolio might have exposure to.
- [07:19]
A
Absolute. Absolutely. It's unbiased. Right. It's, it, it, it goes wherever the trend is, irrespective of those things. And I think that adaptability of momentum is why it, I mean, over market caps and geographies, you know, in sample out of sample, momentum is one of the best performing factor premiums, I think, precisely because of that adaptability, where it just goes wherever the strength is. So it can outperform over long periods of time because of that adaptability. But I think you bring up a really important point though, because there's a, there's a, there's a jump you have to make from, we believe anyways, from just getting momentum exposure to getting positive outcomes. And so decisions like when you rebalance, how you rebalance, how, how often you rebalance, all those small decisions make a huge difference in outcomes. So, you know, when you mentioned that, you know, moving, moving from heavy tech to heavy energy within a day or a couple weeks of rebalancing, obviously that might be suboptimal in terms of making huge wholesale changes, you know, at one time.
- [08:27]
C
And we're going to get into all that. We want to ask you about all those things in terms of. Because I think that was sort of. Our next question is a lot of people think, oh, momentum, you know, you're just measuring this time frame and it's so easy to build these strategies in the real world. But the reality is there's a million decisions going on behind the scenes that have to be made correctly to implement this. And it's hard to do. It's not simple.
- [08:45]
A
Yeah, yeah, the theory is simple. Right. And I think that's where it gets confused. You know, it's, it's a, it's a discipline where you can get last year's paper. Right. And do. I don't know if we look at newspapers anymore, but you know what I mean, you can look at last year's performance and that's your portfolio. So it's very simple in theory, but yes, Very difficult in practice. And that, and that's, you know, where we come in as a firm.
- [09:07]
C
And it's interesting just going back to your point on growth, I think growth is probably the one place that those of us are that are quant investors probably have the most difficulty. Like there's a lot of value strategies that are quant that work. There's momentum strategies, there's quality. But you know, because growth gets you in those expensive stocks where the universe doesn't work over time, like that's a tough place to find quant strategies that actually work.
- [09:25]
A
Yeah, yeah. And look, you know, growth from an academic perspective is basically the opposite of value. Right. Like owning expensive. And the premium, if you look at it doesn't work quite well over the, over the, doesn't work well over the long term. But I think there's a nuance there. Like our research, we don't, we're not saying that growth managers can outperform, but generally they'll outperform because they're exposed to momentum quality or value. So we would be say, go straight to the source. Because the problem with growth or owning expensive is you'll have runs where it does very well, but it tends to be boom and bust. Right. So the late 90s is a great example. Into 21 is another example where you have these really strong excess return runs. But it always generally is followed by a deep valley of underperformance. And those valleys are what hurts the growth premium over the long term. So one of the great things about momentum is if growth has trend. So growth as a, you know, traditional growth has trend, momentum will load on it, but when it loses trend, it moves away. Right. So, so that's kind of the, the difference in adaptability from momentum versus growth.
- [10:33]
C
They mentioned 12 minus 1 momentum before. I wanted to ask you about the time frames over which momentum works. So you mentioned, you know, one month, you know, you probably don't want to use because it reverses, you know, one year minus the one month is, is one that's commonly used in academic papers. But what do we know about what periods momentum, you know, would we can measure it over where it works going forward?
- [10:52]
A
Yeah, there's been a lot of research in this and generally speaking, I mean Jaggedish and Tippmann were kind of the first ones, right. Like the early 90s. And they, they, they showed that, you know, and our research suggests too that any look back period actually works pretty well. So 3 months, 3 minus 16 minus 19 minus 1, 12 minus 1. The, the problem happens in, in terms of, and we can get into this later, but the problem happens in terms of your holding period. But so generally speaking, the more you turn over, the more you rebalance a momentum strategy, with some exceptions, but generally the more you rebalance, the better the outcomes. And that's really where the rub comes in with momentum is it's very strong academic theory, but obviously if you're turning the portfolio over a tremendous amount, it could erode the alpha proposition. But generally every look back period, depending on your holding period after that formation period, can really impact results. But Generally speaking, the 12 minus 1 is the strongest kind of balance of outperformance. So robust premium and then a turnover that's actually doable in real life.
- [11:58]
C
How do you think about explaining why momentum works? You know, one of the things we see with investors, and I don't know if you see this as well, is when you, when you explain momentum to people, you explain to them, you know, we're buying the stock because it's up over these periods. And then they say, well, well, tell me about the business, like why? I want to know what's going on the business, why is it going up? Like they have trouble connecting the fact that there's incredibly strong evidence supporting momentum with their, their thought process, you know, looking at the store around the corner that they're investing in that they want to somehow tie that to the business. So how do you explain to investors why momentum works?
- [12:26]
A
Yeah, and that's one of the key challenges for momentum to be more accepted because you're right, it's a very strong, robust, persistent premium over not just equities, but over other asset classes as well. The way, and I would just point out firstly that we're practitioners at heart. I mean, we do a lot of academic research, but we really came to our views as practitioners. So through intense observation over almost three decades. And so there's two arguments that are made about why momentum works. One is a risk based argument in terms of being compensated for the added risk. The other is behavioral. And we fall firmly in the behavioral camp. We see every day. We see a chronic underreaction, at least at buy point for a momentum strategy, a chronic underreaction to positive informations or new trend. And then so at buy point it's an underreaction, so it's behavioral. And then at sell point or around the sell point, there's also an overreaction to current trends. So we see it as investor underreaction and overreaction, which creates the momentum premium.
- [13:30]
C
Yeah. In a lot of Ways it's the opposite of value. Right. In value, we've got the overreaction to bad news and momentum, we've got the underreaction to positive news.
- [13:36]
A
Absolutely. And that's why they're such a great pair to have both of those momentum and value in your portfolio.
- [13:42]
C
And we're going to get into that too in a little bit. But first I want to ask you, you mentioned turnover before, and that's one of the criticisms of momentum strategies, which is the idea of because so much turnover is required, does it survive transaction costs? So what do you think about that?
- [13:57]
A
Yeah, so I think it does. But there has been a pretty strong debate in terms of academics and practitioners over the years. And if you look at kind of the seminal work from academics, and this was all kind of early 2000s or actually in the 1990s, that basically said momentum doesn't survive trading costs. A lot of those studies were actually before decimalization in the stock market. So trading costs were a lot higher. And obviously we've seen since then trading costs come down. But there's also practitioners like AQR, BlackRock, to name a couple, that have come out and said, well, yeah, these academics, they got the cost a little bit wrong. You know, with modern trading and trading strategies, they found something like they're overestimating the cost by like 5 to 10x. So costs have come down. We did a paper on it as well and we found that trading, if done, if, if done carefully, momentum can survive, you know, frictional costs or trading costs. But I think what's right to point out though, is that momentum, to be successful, you have to have turnover because while the, the premium's persistent, it's robust, it does decay quite rapidly through time. So our, our, all of our research and other research suggests that the momentum premium, you know, after that 12 minus one formation period, let's call it, generally gives you alpha for about six to nine months and then after that it actually turns against you. So that means that you need to have, you know, 150 to 200% turnover rate to really extract that momentum premium. So trading costs are an important consideration for any momentum strategy and if not done carefully, you know, can erode alpha.
- [15:40]
C
Yeah, that's a good example of why it's so important when you look at academic research to sort of think about it in a real world context, because, I mean, the academics do the best they can, but it's hard for academics to project what trading costs would be on a strategy and not doing any trading. So, so like with strategies like that, you've kind of got to think about that in both directions before you just take academic research at face value.
- [15:58]
A
Absolutely. And that's where I think a little bit of our edge comes from, is that we've developed our processes through practice. Right. Through experience of knowing what works. And that's why, you know, we can get into this a little bit later. But you know, we think actually the highest expression of momentum investing is actually prices reflecting business. So it's the confluence of price momentum actually a signal for businesses doing well. And so if you combine momentum and businesses doing well, I think you get a better alpha proposition and you get lower turnover because these companies, where price is reflecting a business doing well, you tend to get a longer duration of outperformance and a higher amplitude of outperformance.
- [16:40]
C
How do you think about tax efficiency momentum? Because that's another one a criticism people have because of the trading. And I guess a lot of this depends on which vehicle is being run and a lot of other factors. But how do you think about tax efficiency as it impacts momentum?
- [16:52]
A
Yeah, I think there's a, there's a perception that higher turnover equals tax inefficiency. And I think in general that might be correct. But in a momentum strategy it can actually get you the wrong thought about it because it depends what that turnover is about. Right. So a momentum strategy is actually much more tax efficient than most people think. In fact, it looks as about tax efficient over the long term as a value strategy because of of two key characteristics. One is a momentum strategy tends to hold on to its winners longer. So your higher capital gains, you know, get, your longer held capital gains get treated differently. But also a momentum strategy also has short term losses to help offset those gains. So momentum is a strategy where you're always moving to the winners, your winners run longer and you cut your losses short. Right. So you generate some short term capital gains that help offset it. Whereas value, and also the last part about momentum, it tends to be over time less exposed to dividends which have a higher tax regime. So you put those two things together and despite momentum having like five times higher turnover than value, the tax efficiency is almost the same over long periods of time. So we've seen that with our strategies. AQR did a great piece on that. Moskowitz and Israel did a good piece on that, saying essentially the same thing.
- [18:14]
B
I'm just curious, like when you're building a momentum portfolio and let's say there's, Whether it be 10 stocks or 100 stocks, I think some of your strategies might hold, like depending on the, you know, the mandate, then maybe upwards of a little bit north of a hundred securities. But do you, do you allow or do you, do you differentiate at all? Like, I'm thinking if a stock goes from like a relative strength of like 99 to maybe 89, I mean, maybe it, there are better scoring, higher scoring, relative strength stocks out there, but maybe the drop in momentum isn't as much as maybe some other stocks in the portfolio. So do you take that into consideration on. The reason I think that's important is because people that use, you know, simple screening tools out there, which there are many that, you know, help investors try to find high momentum stocks. It's like when they're building their own portfolio, thinking about how, you know, to manage that, because maybe those two momentum stocks, the one that goes from 95 to 89 or whatever it is versus the one that goes from like 95 to 30, you know, that's clearly much more of a, a decline. So I'm just curious how you guys kind of view that.
- [19:24]
A
Yeah, we view it in, we use a lot of more signals in our panel on both the buy side and the sell side than just your standard, you know, price score, price momentum score.
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B
Okay.
- [19:36]
A
So we look at things like obviously, you know, relative strength momentum scores, but we're also looking at stock trends, you know, broader trends, medium term trends within that security. And then we're obviously looking at fundamental trends as a guide to make those decisions. So if that drop from like you said, 99 to 81 is significant or not, and generally we think we view it as significant if it's also meeting some kind of fundamental change or fundamental trend violation. So for us, it's, it's a mixture of very, we're very systematic investors, but we're using kind of more fundamental information to help guide our decisions. And we think the, the confluence of obviously starting with momentum in terms of trend, of what works. Right. Being obviously always exposed to that, but improving outcomes by understanding the rationale about why that company is doing well and following fundamental trends. So for us, it's a, it's a, it's a, it's a combination of all these signals together that help you decide more than just a score, you know, what you need to take in terms of moving the portfolio, what you need to take into consideration.
- [20:43]
C
Yeah, I think Justin's point gets it. The difference between the way you see a lot of retail people run momentum and the way like practitioners run momentum, because retail people might run their top 10 screen. And then the next month, you know, a stock has moved to number 14 out of thousands of companies. And they're like, well, I gotta sell it because I gotta only own the top 10. And you end up with crazy amounts of turnover where someone like you doing this is gonna run a much more thoughtful process to think about what should I be taking out? What should I be putting in?
- [21:07]
A
Yeah, correct. And, but. And I think you always got to look at it in the context, especially in markets like this, right. Where it's like there's a lot of noise and a lot of volatility. Yeah, you got to look a little bit more. More of a craftsman style. You know, obviously I. We believe the consistency and repeatability of having, you know, very strong systematic approach, but always understanding, you know, through, you know, human experience how to improve outcomes. And so, yeah, if a company goes from like a 80 relative strength to 79, do you need to take action or not? You know, those are the kind of judgment calls that come in sometimes.
- [21:43]
C
So you mentioned fundamental momentum. And I definitely want to ask about this because this is a really interesting debate. You know, some momentum investors will say price is everything, you know, so if fundamentals are improving, that signal is reflected in the price. And others will say, no, combining the two together, having a price signal, but also adding signal in terms of improving fundamentals improves the momentum strategy. So where do you come down on that?
- [22:03]
A
Yeah, definitely in the middle of that. So I think price is obviously extremely important, but through our experience, we've seen kind of the best outcomes through a combination of, of, of both those things. Be. But. But you have to be balanced. You have to be careful. Right. Because momentum is very strong precisely because it's so simple. Right. It's at, it's at its strongest form, though. We still think that, you know, price should reflect something. Right. Something positive going on at that company. Otherwise we would call that a false positive. And we have seen more often that the companies that have strong price momentum, especially dynamic momentum, where momentum score is, you know, because of one day's price performance, you know, one piece of news has moved the stock up. So the score, you know, becomes very good based on one day's performance. And if there's no reason really strong rationale behind that, you tend to get that those are the stocks that tend to reverse on you. So we come down firmly in the camp that the highest expression of momentum is price reflecting something and not just price.
- [23:04]
C
How do you think about defining that something? Because to some extent, you know, people could define that something in a way that it becomes growth. So you're looking at earnings growth or sales growth, but you could also look at things like, you know, improving return on equity or improving profit margins or something like that, which are not necessarily growth. So how do you think about defining fundamental investing?
- [23:20]
A
Yeah, for us it's so obviously we have a strong panel of momentum scores and not just price performance. We look at things like 52 week high relative strength, new high, other signals of price. We combine that with positive estimate revisions as a sign of fundamental momentum, if you will, and also earning surprise as an underestimation of what's happening. And then from there, when we're looking at a company to include in the portfolio, we want to see financial improvement. So it's not about like, you know, the, the rate of growth or anything like that. It's about improvement. So financially improving companies, whether it be the top line or the bottom line, but we want to see acceleration and improvement in terms of the company's business fundamentals because we think that underwrites continued momentum in price.
- [24:04]
C
And what's cool about the improvement lens is, you know, thinking back, like we have some strategies that combine price and fundamental method. And like coming out of 2020 and like 2021, a lot of those strategies were in value stocks because the value stocks had the most improving fundamentals. It wasn't, it wasn't growth companies at all. And so it allows you to be more flexible, I think when you look at it through that lens.
- [24:22]
A
Yeah, definitely. And look, there's a lot of academic research too. I mean the concept of twin momentum, which I know you're familiar with, I thought that was an interesting academic paper which we kind of agree with. Novi Marks at DFA actually had a, you know, a paper talking about momentum and fundamental momentum and whether there's a difference or not and whether that's momentum only exists if there's fundamental momentum. So there's been a lot of, of academic research, but again, we come at it from practitioner perspective where we have, through almost three decades of doing this, just seen and observe that your best momentum stocks are ones that have, are buttress by improving financial performance and that that trend is reflecting something important at the business. So at its essence, we believe momentum is as simple as having some piece of your portfolio and companies doing well. Right now, that's about as simple as you can get.
- [25:13]
B
And Travis, you kind of hit on this earlier, but, and I remember reading this in Quantitative Momentum, which is a book by Wes Gray and Jack and great book.
- [25:21]
C
Just.
- [25:22]
B
Yeah, can you just things that, and I don't know if you incorporate this in your process, you can kind of speak to it. But they sort of highlighted the. How continuous momentum.
- [25:32]
A
Yes.
- [25:33]
B
Was superior, I think, versus I think they called it like discrete or inconsistent interior. What made me think of that was your, like you made the point that, you know, the one day pop or the one day, you know, might move something up or down from a, you know, momentum rating standpoint. So anyways, I thought that was interesting. If you want to sort of just explain what they found there.
- [25:55]
A
Yeah, yeah. And there's, it's a little nuanced, but it's called kind of the frog and pan hypothesis is right.
- [26:01]
C
Where, Right.
- [26:02]
A
Yeah, yeah. Well, you know the analogy like you throw a frog in a boiling water, it's going to jump out and, but if you increase the temperature slowly, that's not going to know. Right. So yeah, there is some good evidence in terms of more discrete. Now you got to be a little bit careful because there's a lot of research on this theory whether it's, whether it's discrete information, so, so small piece of information over time, more continuous momentum or the volatility of momentum, they're not necessarily the same things. And I think, you know, one kind of talks about how many positive days versus negative days as a kind of measure of discrete. We call it kind of dynamic MO or grinder mo. That's how we kind of think about it. But yeah, we incorporate some of that research within our process. We're actually, we're actually reviewing right now whether it's a good portfolio weighting tool like up waiting, more discrete momentum and down waiting, more dynamic, or is it a strong signal that you want to capture in terms of a new idea or something like that. But we've, we, we have seen through our experience that there is something to that. So we very much are a believer in you want to have some combination of dynamic momentum or these jumpers, if you will. But also you need to be understanding that the discrete momentum is powerful as well.
- [27:23]
B
So that's, that's interesting. Like you guys internally, you're, you're, you're looking at it whether or not you might weight stocks higher or lower based on this concept or whether it becomes an actual signal that determines like a buy or sell. Am I understanding that correctly?
- [27:37]
A
Correct, correct. And we're recreating it across all because one of the things we do at Inform Momentum company is we're, we're obviously doing momentum investing, but we're doing it across the world. So we have, you know, and across market cap. So global. Em. Non us, us. So we're recreating all of it for every different market to make sure that, you know, out of sample, it's very strong as well. But I think there's something to it. But the one thing we're cautious about is, you know, in certain industries, like probably the greatest example is biotech, where all you're going to get is generally dynamic moments, right? You're going to have some information about, you know, their drug or their therapy and it's going to totally. The perceptions of that therapy are going to change dramatically in one day. And so we've seen a lot of performance from those types of companies over the years. So you don't want to totally exclude dynamic momentum. But, but it's something to definitely be aware of.
- [28:31]
B
Based on your research and testing, are you. Do you find, I mean, it's persistent across all these different markets, but is there more alpha in certain areas and others like you mentioned, em, or maybe small caps or, you know, what does your research show on that?
- [28:49]
A
Yeah, we will. Yeah, you're right. We've shown it to be a very persistent source of excess return kind of across market caps and geographies. But like most factors, it tends to be in values kind of the same. It tends to do better the smaller you go. That's just a kind of a general rule for most factors with the exceptional quality maybe where it does quite well and in larger cap stocks. So yeah, there's, there's kind of a small cap effect on momentum as well as other factors. The one exception, and it's kind of the exception to all, all factors and everything, is Japan. Japan's kind of an anomaly where nothing's worked very well over the last 30 years. Even the beta returns are pretty low. But that's a market where value does really well. It does better than momentum. It's one of the only areas where momentum isn't the best performing from an excess return perspective. So Japan's a bit of an exception. And then I would say on the other side, emerging markets. In, in every market we test, there's usually a combination of, of momentum, value and quality, which gets you an optimal portfolio, like maximizing information ratios. But emerging markets, we find you really only need value and momentum. So momentum works extremely well in emerging markets, particularly emerging markets, small cap.
- [30:04]
C
To your point on Japan, we had Dan Rasmussen from Rodado and I believe it's almost impossible, if not impossible for a company to go bankrupt in Japan and I think that's part of why value does much better because you take that bankruptcy risk, which is certainly the case with many value companies off the table.
- [30:19]
A
Well, yeah, and look, I think factors are also, the performance of factors are also determined by the dynamics of the market. There's some, some evidence that, I think there was Hanauer that did a study on it, momentum in Japan and what he found was the reason why momentum hasn't worked very well. And I say worked meaning generating excess returns like other areas, but it still offsets value. So there's still some utility, but it's because it cycles. Japan has cycled for the last 30 years to like boom and bust, right? It'll rally and it'll sell off and, and over time it's just going nowhere. But a lot of volatility. So there tends to be this kind of option like payoff to value in Japan on those recoveries, which gives it kind of a higher premium than, and probably the bankruptcy thing you talked about. But we did a study on Japan and we just did a simple, you know, how do we improve momentum returns in Japan? And so you start with momentum, but then if you sort that momentum portfolio or that momentum bucket by value and you pick the highest quintile of value stocks within that momentum bucket, there's some evidence that you can improve the momentum returns. So skew a little bit more value in Japan and you probably have a little bit better outcomes.
- [31:29]
C
You mentioned some things you were looking at for your strategy a minute ago. And I think that's one of the things people have misconceptions about, about factor investors. They think we just kind of set our strategy and we forget it and we rely on long term data. But the reality is we're always thinking about making changes, but probably not making them that often. And I'm just wondering how do you think about that process of judging? Like you have your long term strategy in place, but you also know things change. Like a good example is value investors recently is price to book. I mean a lot of value investors were big fans of price to book and many are not now. How do you think about that process of making changes to your portfolio but still sticking to your long term principles?
- [32:01]
A
Yeah, totally. And we, I mean you, you, you kind of summarize that really well. You have to, you always have to be introspective and, and try to get better at everything you do and learn whatever you can from your past mistakes. So we've always evolved our process and over time to get better and as signals kind of Come and go and fade. So we track all the ICs or information coefficients on all of the signals we use. But you also have to be careful of not overfitting. Right. Or over learning where you're changing, you're making changes based upon 18 months of data or 2 years of data. So you always have to push the envelope on evolution and getting better, but at the same time not over learning. So in your value example, you know, you can overfit value to not be value anymore. And then if value comes back, you're not there. So, you know, you got to be very careful about over learning. But I'll give you a kind of, a quick, kind of funny example of it because, you know, we've been doing this for quite some time and we're actually doing momentum investing in a pre reg FD world in the US Which I. So in that time period, we used to use analyst upgrades and downgrades as a signal of momentum. Right. So more upgrades versus downgrades. If it's positive, it's good. But that was when there was information that they had that other people didn't have. Right. Asymmetries of information. And ever since that, it's kind of lost its value. And it's almost perverse, most often where you want to buy the downgrades and sell the upgrades. So that's an extreme example of how signals can change through time to your point of value.
- [33:33]
C
It's interesting because one of the things I always say to people when they're like, I've found a great value strategy over the past decade, it's totally trounced the market. My first reaction is it's not a value strategy. I think that's the only. That's the only possible example because like you said, you've probably dumbed down value in a way that you're not actually measuring it.
- [33:50]
A
Yeah, yeah, exactly. We have a. One of my favorite stories is David Wrisky, who works with us and does a lot of our momentum research. You've probably seen if you go to our website. And by the way, all our research is on the website. On our website too, if you want to. If you can't sleep at night and want to read some. Some things to help you get to sleep faster. But anyways, he tells us a great story about one of his research projects. It was on a factor and they didn't want to admit that momentum was the factor. So they were trying to create all these other signals that they could kind of subsume momentum without being momentum. And they had this, I forget what the exact factor was, but it was like at the end of the day, it was like, oh, you're subsuming momentum by being momentum. You're not at is because it's one of those things that momentum is one of those things that some investors just don't want to admit that works. So they try to get around it by doing all these other factors. But at the end of the day, you're just getting momentum.
- [34:44]
C
You mentioned the momentum requires a little higher turnover than some of the other factors earlier. How do you think about how often to rebalance over momentum strategy?
- [34:51]
A
Yeah, gosh, we think about that a lot. But the way, the way we have found that has been much better in terms of your trading costs but also your outcomes is we. So we don't wait for a calendar to rebalance the portfolio like every month or every quarter or whatever. We measure our signals and our portfolios every single day across all the momentum signals that we capture. And so we rebalance every day, but stock by stock incrementally. So when the signals tell us to move, we move. So momentum for us is an everyday type mentality. It's like trench warfare to, if you do momentum well, you got to be engaged every day because things change rapidly. So we don't think about, you know, we're going to rebalance quarterly or monthly. We think about we're going to rebalance as often as the signals tell us to. And over time that's been around what we think is considered somewhere around optimal range, which is like 200%. Right. So that's the most dynamic alpha creation from momentum portfolios is kind of that 6 to n month holding period.
- [35:57]
C
And I think that's an important distinction too because people don't realize rebalancing frequency and turnover are two different things. Correct. You can rebalance very often but make small changes and still not have high levels of turnover.
- [36:07]
A
Absolutely. And so we're firmly in the camp in the belief that you want to make small incremental changes, even daily, to really give you, give our investors that persistent exposure to momentum and be more, much more optimal in your buy and sell points. Right. Because if you're just picking a day on a calendar, it can't be the fact that that was the optimal buy and sell point for 30% of your portfolio that you're turning over on one day. Right. So we much very believe in that incremental stock by stock and moving when the signals tell us to move.
- [36:37]
C
How do you think about portfolio size? That's Another thing where factor investors will differ. You have some investors who want to have the highest exposure to their factors. They want very focused portfolios. Others say we're betting on average on the factors. So we want to be a little bit broader and make it a little easier for investors to stick with. Like, how do you think about that?
- [36:53]
A
Yeah, yeah. And we would say. One of our clients described us as hardcore momentum. So we, we want to deliver that pure momentum exposure because we know in most of our clients portfolios we're offsetting something else. Right. And generally it's value. You know, momentum and value tend to be negatively correlated and they both perform well over time. So you put them together and you look more smart more of the time. So we're, we're hardcore. But you need to have diversification enough where all your eggs aren't in one or two baskets. Right. So whether that's top decile, you know, top 10% of your selection winners or top five. For us, you want enough diversification to, to, to really harness the power of momentum and not too much where, you know, one or two stocks are going to torpedo your results. So it's all about process and diversification without, without the dilution of your intent in the first place. And for us, look it, we're a little bit more concentrated than like a top decile or top, you know, quintile strategy because again, we're looking for the confluence of price momentum and fundamental momentum. And that, you know, that when that comes together, that's how we build our portfolios.
- [38:02]
C
Along those same lines, how do you think about sector concentration? Will you over concentrate heavily in a sector if it has lots of momentum, we will.
- [38:09]
A
We're not afraid to be different than our indexes. However, we also don't want to crowd out what we believe to be compensated risk, which is for us is momentum and idiosyncratic exposure within that momentum bucket. So on like a country or industry perspective, we look at our contribution to active risk, you know, like percent of your predicted tracking error. We don't want to have more than 20 of that risk be due to our country overweights and underweights. Because the biggest risk with momentum is it works till it doesn't. Right. So, so, so if you have all your eggs in one or two baskets, there's, you're just setting yourself up for, you know, some, some pretty bad downside.
- [38:46]
C
Capture just one more for me before I hand it back to Justin on this idea. If it works until it doesn't is this idea of momentum crashes, which Is, which is something people talk about as, as a criticism momentum, but also something, even if it's not a criticism, something for people who run momentum strategies who are invested in, to understand about momentum. So can you explain what a momentum crash is?
- [39:05]
A
Sure, yeah. It's a severe correction in a momentum strategy and this gets into the riskiness of momentum versus value. And we can get into that as well. But yeah, momentum tends to have these short, sharp, sudden corrections, which gives most of you of that it's overly risky. But generally a momentum crashes when the leadership reverses. Right. So when a group of stocks or securities have been trending, if something happens in the market, like generally a market volatility event, what you have is the leadership stocks changing so the winners lose, but more importantly, what happens generally in momentum crashes. So if you look at the top 15 worst months for momentum, it's not necessarily those winners being sold, it's the loser side of your portfolio that you don't own that crashes upwards. Or in a long, short momentum strategy, it's what you're short. Right. The loser side, which tends to be value. And so momentum crashes, if you look at the history, generally occur after a market decline and the subsequent early stages of a market recovery because the loser side of the equation has accumulated market beta, which then explodes to the upside in a, in a market recovery. So there's a little nuance there in terms of long only momentum and long short momentum. But generally speaking, it's the loser side crashing upwards that really defines a momentum correction. But. And all those ones we looked at in the top 15 worst months for momentum ever, going back to 1926, if you combine a momentum and value strategy, in 75% of those months, you had a positive excess return, which shows you the extreme hedging value of combining momentum with value.
- [40:54]
B
You talked about this perception that momentum is more or perceived as being more risky than value. And I think the paper you wrote, maybe you wrote a few of them, but the one I'm looking at is risky business value versus momentum. So can you just talk to what sort of the findings were from that paper and from the research?
- [41:14]
A
Sure, yeah. And so the findings really simply were that if you look at objective criteria and we did a us long only momentum versus us, you know, value, you know, using Fama French data going all the way back to 1926. But we actually did a sub sample period from 1950 on because value got really risky in the 20s, late 20s and 30s. It was wild. But if you look at objective criteria data like standard Deviation, tracking error, even drawdown analysis, you would conclude just from that pure objective perspective that momentum is actually less risky than value. So Value had higher tracking error, higher standard deviation, more drawdowns, more extreme drawdowns than momentum, which I think most people are surprised at. But it gets to, you know, one of our clients said that, you know, when, when value underperform, it's like a death by a thousand cuts or he said, getting kicked to death by a duck, it kind of incrementally underperforms, but over a long period of time that accumulates into these, know, bigger corrections. Whereas momentum, it hits you in the face, right? It's short, sharp and sudden. So you, you just feel it more with momentum, which gives you that kind of, most investors that negative connotation of momentum being overly risky. But when you look at it just objective criteria and all those types of variables, I think the most conservative estimation would be that momentum and value are at least as risky as each other. So if you're comfortable with value risk, you should be comfortable with momentum.
- [42:45]
C
It was, it was interesting. Larry Swedro had a paper about this and he was looking at, and I think a good way to measure risk for your average investor is how often do you underperform.
- [42:53]
B
And he was looking at the rolling.
- [42:55]
C
Three month, you know, three, sorry, three year, five year, 10 year periods and saying which factor underperformed less and momentum underperformed significantly less than value. Could you look at in that framework?
- [43:05]
A
Yeah, we saw the same thing. We did the same analysis in that paper and found the batting average, if you will, of momentum being higher than value. So you actually outperform more often as well. So yeah, there's just some misconceptions with momentum, but I think really that it's, it's momentum done well. Right. We have to make that caveat. There's a lot of momentum strategies that might not have that, you know, type of risk. So you gotta, you gotta do your homework. When you're looking at momentum strategies and all these little details, when you translate it from theory to practice.
- [43:33]
B
The other thing that I think his Swedish table showed is when you combine sort of multiple factors together, you sort of lower that possibility or of like long term underperformance of that a factor can go through. But how do you think about it sounds like, you know, you're using more than just momentum, as you've explained. But do you think at all about the other benefits of coupling momentum with something like value or something like quality?
- [44:01]
A
Yeah, definitely. We'd be a strong advocate of Always balancing exposures within a portfolio. And so we, we think obviously long term you want to be exposed to premiums that have shown to pay in, in terms of excess returns and combining those that perform at different times. So in, in most of the analysis we've done for our clients and you know, through market caps and geographies, the optimal portfolio has some combination of momentum value and quality and the weightings between each one kind of varies in terms of what market cap and what geographical area you're looking at. But always there's a combination that gives you better outcomes. So momentum has a utility in terms of if you're going to pick one, the strongest excess return may be good over the long term, but we really see very strong outcomes on a risk adjusted basis. By combining momentum value and quality in kind of a diversified portfolio has anything significantly.
- [44:59]
B
I'm just thinking about your development as, or your, I guess as a momentum investor over time and, and is there anything that jumps out at you that sort of, you, you thought something about momentum like earlier in your career, but as you've evolved and, and through your research that has anything changed considerably like in your mind with momentum investing, would you say?
- [45:21]
A
No, I think nothing's changed in terms of, of the mechanics in terms of momentum working. And I think it's been remarkably persistent through time. And there's probably a lot of different reasons for that. One is the rise of passive, which we can talk about. I know that's a big subject, which market cap weighted is kind of a weak form momentum in itself. But I think one of the things that we've learned as a group is that momentum's powerful enough that you don't want to get your ego or your emotion in the way of, or your perception of, you know, what rationale is better than the other. From a qualitative perspective, I think the power of momentum is, you know, not getting in the way of it too much in terms of what you may think about a, a company. So I would see that that would be kind of the biggest learning lesson. I think when you're younger, you think you, you know more than you really do. And I think as you get older and more experienced, you realize that, you know, let's just get our, have our investors assets on the right side of these powerful signals and, and not get in the way too much in terms of, you know, messing with that. So I think that's probably the, the learning lesson over the years, you know, humility and, and, and having no ego or emotion about these decisions.
- [46:35]
B
That's important stuff. Let's talk about the rise of passive for a minute because that's something that we've talked about a lot on the podcast with different people. How do you, where do you sort of fall on the influence of passive flows on stocks and yeah, just where do you come down on, on what's happening in terms of market structure with that?
- [46:54]
A
Yeah, I mean, I would say that it's from a day to day looking at stock behavior. I think it has to have some impact. Now how much of it? I don't know, but I mean you could see it with the reactions when companies get added to, you know, an index and the indiscriminate buy in that happens and the, the changes in terms of market cap that happens because of that. So there is some impact in terms of market structure. There has to be. But the other thing that I've, I mean, look as an active invest, as an active manager, you can look at the rise of passive and, and fee compression and it's something that you don't like necessarily. But on the other side, as a momentum investor, I kind of look at it like, well, there is some positives because I mean, I guess we got to define what passive means. I guess market cap weighted is kind of the, what most people do. Right. Which in its essence is kind of a weak form momentum strategy. So it actually creates a little bit of a tailwind. Right. Because the only way you get bigger in market cap is you're outperforming and then the fund flows disproportionately affect you. So there is a little bit of tailwind, I think for momentum because of the rise of passive and how they're built and how these, you know, indexes are built. So I guess it's a love hate relationship with passive for us anyways. But yeah, I mean, it's also, you know, a reason why I think you have to combine, you know, price performance with, you know, the reasons why things are happening and, and maybe a discount, you know, momentum because of an index addition, you know, versus another security that doesn't have that kind of indiscriminate buying.
- [48:20]
B
So Travis, we have two standard closing questions that we'd like to ask you. We asked this of all of our guests. The first one is what is the one thing you believe about investing that you think the majority of your peers would disagree with you on turnover?
- [48:33]
A
I would say that it's turnover. I think there's a kind of a universal reaction to turnover as turnover being bad. And so I think I would differ Most saying that, well, turnover should always be a reflection of the underlying strategy. So like in a value strategy, if you have a five year horizon. Yeah. Then high turnover is probably not good because you're not, you're not, you're not, you're not, you're not executing on that strategy. Right. But for a momentum strategy, you know, you don't want a momentum strategy with low turnover. That much I know. So I think, you know, the fact that turnover being universally bad is probably, you know, one thing that I differ with. I think it just depends on the strategy and what you're trying to accomplish. And so I don't think there's one answer, you know, high turnover bad, low turnover good.
- [49:18]
B
And the last one is based on your experience in the markets. If you could teach one lesson to your average investor, what would that be?
- [49:25]
A
I think it would be diversification. And that goes a little bit with not wrapping your ego and your emotion into stock movements, you know, because I think that's probably the biggest lesson to learn is that it doesn't matter how much work you've done on a security, it doesn't matter what you think. It really matters what the market thinks. And so part of that humility is knowing that you don't know which factor is going to outperform or you don't know what's going to happen in the future. So it just behooves you, I think, to be diversified and unemotional about these decisions. So I think it would be the lesson that I would teach my kids and everyone else would be know, stay diversified. When one thing gets too extreme, rebalance it back to that kind of balance portfolio and then not just get emotional. Don't tie your ego with stock price movements because you're going to have an unhappy kind of life. And investing if you, if you do that. So unemotional and diversified.
- [50:20]
B
Excellent. Thank you very much, Travis. We appreciate it and enjoy the conversation.
- [50:24]
A
Yeah, thanks guys.
- [50:25]
C
Thanks so much for tuning in to this episode.
- [50:27]
B
If you found this discussion interesting and.
- [50:29]
A
Valuable, please subscribe on YouTube or subscribe.
- [50:31]
B
Your favorite podcast platform or leave a.
- [50:33]
A
Review or a comment. We appreciate it.
- [50:35]
C
No information on this podcast should be construed as investment advice. Securities discussed in the podcast may be holdings of the participants or their clients.