Excess Returns with Momentum

Excess Returns with Momentum
May 3, 2012

“[Momentum is] the single largest inefficiency in the market. There are plenty of inefficiencies, probably hundreds. But the overwhelmingly biggest one is momentum.” — Jeremy Grantham

Momentum defined
In its simplest form momentum can be defined as the continuation of existing trends in the market, where increases in prices are followed by additional gains, and decreasing prices are followed by further losses.
Why it exists
While momentum is an investment strategy with strong empirical roots, it is helpful to think of it as a natural extension of actual human behaviour. For many years, scientists in disciplines as seemingly unrelated as evolutionary anthropology and modern psychology have demonstrated that humans are prone to the same herding instincts as other animals. That is, when faced with a choice in the absence of trusted information, humans will usually choose to follow the crowd rather than act against it.
The dominant investment paradigm embraced by almost all contemporary investors emphatically denies that this human condition exists, preferring to think of human decision makers as computational engines that operate independently and have a perfect understanding of the odds. In contrast, smart investors recognize that one of the most powerful forces in human decision-making is ‘social influence’, and work to take advantage of this human condition to deliver out-sized performance over time.
Enter momentum analysis
To illustrate the persistence of the momentum phenomenon over time we compare four fictitious portfolios whose investment universe is comprised of the 10 major global asset classes (U.S., European, Japanese and emerging market stocks; commodities; gold; U.S. and international real estate, and; Treasuries (intermediate and long).
At the end of every month we rank each asset class based on their six-month trailing returns. Then we adjust the holdings of each of the four portfolios based on the rankings: the first portfolio will only invest in the two top-ranked asset classes of that month, the second portfolio will hold the top half(5), the third will hold the worst half and the final portfolio will hold the worst two. These positions are further adjusted for volatility (refer to our separate Volatility Analysis report).

If, as many experts say, the markets are indeed efficient, and the movements of risky assets are random in nature, then the returns of these portfolios should reflect this randomness and this ranking mechanism should have no effect. What we observe, however, is a different story altogether.

Probability that top n ranked assets by 6 month momentum will perform in the top half the following month.



Source: Yahoo finance, Gestlatu.com

In reality the best performing portfolios by far were those with the highest momentum. Of course, any avid Efficient Market Hypothesis practitioner would question whether this type of simple, but actively managed strategy is capable of outperforming an even simpler buy-and-hold investment portfolio. The chart below compares the top two momentum portfolio against an equally held portfolio of all 10 asset classes rebalanced monthly.

Equity lines, top and bottom n by momentum, rebalanced monthly


Source: Yahoo finance, Gestlatu.com

Again we see here the vast difference in return and risk characteristics. The top two momentum portfolio grew at 21.13 percent a year vs buy-and-hold at 8.9 percent. On the risk side we see the largest peak-to-trough loss being -19.42 percent versus -43.90 percent respectively. All of this without forecasting or having to read a single analyst report, that is the power of momentum.
Market inefficiencies are often fleeting and difficult to exploit with any success over long periods of time. By its very nature the market tends to find anomalies  and eliminate them in due course. Momentum, however, seems to fly in the face of this reality. This is because as long as markets are driven by behaviourally flawed participants that make decisions based on herding, this phenomenon will continue to persist and we will be able to exploit it.
With this final step, in combination with active diversification (link coming soon) and volatility management, we are able to offer one of the most  stable and adaptive wealth management systems available to anyone today.
While uncertainty still reigns supreme in global financial markets, our Darwin Strategies provide an optimal solution for surviving the treacherous markets of the future. To learn more, contact us at www.darwinfunds.ca.