Say No to Mo

Adam M. Grossman

A FEW WEEKS BACK, a reader—let’s call him Karl—challenged me with a question. Why, he asked, don’t I recommend momentum investment strategies?

If you aren’t familiar with the term, momentum strategies seek to buy stocks that have done well in the past, with the hope that they will continue rising, while also selling stocks that have done poorly, with the expectation that they will keep falling.

Karl asked why, in a recent article, I had dismissed momentum investing as the sort of thing that would turn your portfolio into an “unpredictable stew,” even though research has found that it can be profitable. It’s a fair question.

Karl is right that there’s lots of evidence to support momentum strategies. The most commonly cited paper was published in 1993. Since then, many other academics and practitioners have confirmed that it does indeed pay to buy stocks that have been going up and to sell those that have been tumbling. In fact, there’s enough data to conclude that this really isn’t an open question anymore.

Momentum definitely works. And it’s not limited just to stocks. Momentum also works with bonds, commodities and other types of investments. Indeed, it’s a remarkably durable feature of investment markets. One paper found evidence of momentum going all the way back to 1801. And yet, despite all this research, I still don’t recommend momentum strategies.

Reason No. 1: Costs. Momentum trades don’t last forever. In the 1993 paper referenced above, the authors found that the optimal holding period was just six months. If you want to jump on the bandwagon when a stock is going up, you have to move fast. You can’t wait too long to buy—and you also can’t wait too long to sell.

If you do, there’s a high price to pay: After that six-month holding period, momentum tends to reverse and you could end up worse off. Because of this need to move fast, momentum strategies are expensive. First, all this trading can leave you with a tax bill. Second, trading itself is expensive. In addition to commissions, there are bid-ask spreads. Finally, because so much work is involved, momentum funds are expensive. Even Vanguard Group, with its reputation for low costs, charges four times more for its momentum fund than it does for its standard S&P 500 index fund.

Reason No. 2: Lack of Predictability. Like any niche bet, momentum trading will have periods when it shines and periods when it underperforms. But because momentum is such a risky strategy—attempting to jump in and out when a stock is on the move—it runs the risk of severe losses when the market turns abruptly.

According to one paper entitled “Momentum Has Its Moments,” momentum strategies declined by 73% over the course of just three months in early 2009, when the stock market suddenly turned positive after months of decline. To hedge this risk, you could find another strategy with a negative correlation to momentum. They do exist, and that might moderate your losses.

But that would mean adding two new funds to your portfolio, and you would have the additional question of how to weight them appropriately. And then, of course, you would run the risk of two negatively correlated investments simply canceling each other out. In short, you can have pure momentum, with all the risk it entails, or you could try to manage that risk, but with added complexity and uncertain results.

Bottom line: There’s no question that momentum is a proven strategy. But it’s also expensive and extremely risky. Yes, others might make money with the strategysometimes—but that shouldn’t bother you. The purpose of investing, in my view, isn’t to accumulate the absolute greatest number of dollars. Rather, it’s to accumulate the greatest number of dollars, while also meeting your financial goals and sleeping at night.

Adam M. Grossman’s previous articles include Playing NiceStepping Out and Math vs. Emotion. Adam is the founder of Mayport Wealth Management, a fixed-fee financial planning firm in Boston. He’s an advocate of evidence-based investing and is on a mission to lower the cost of investment advice for consumers. Follow Adam on Twitter @AdamMGrossman.

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Langston Holland
Langston Holland
2 years ago

Another educational article, thanks Adam. On that 1993 paper you referenced, I’m glad today is the first time I’ve seen it as it might have affected the low cost fund buy and hold strategy I started at the time. Other than adding to them and checking the reinvest dividends and capital gains box, I didn’t change anything until 3 years ago after a focusing on a few careers and nearing retirement.

In the paper’s conclusion, which covers 1965 to 1989, they realized a 12% return with their 6 month holding period method. I just backtested buy and hold using the S&P 500 (with reinvestment, without taxes or fees, $10,000 initial with $100 monthly additions) over that period and got an 11% return.

So, you have significantly higher risk, taxes and transaction fees with their method, plus contributing toward your broker’s yacht with all that trading. I’m sure someone could conjure higher returns with another technical strategy using the omniscience of hindsight, but I’ll pass. 🙂

2 years ago

I’m trying to understand what you mean where you write that with momentum funds “so much work is involved”. You clearly differentiate this work from trading efforts. I tend to think of work in this context as gathering data, analyzing it, making securities selections, i.e. more management effort.

But VMFO is charged nothing for management, which is performed by Vanguard’s quant group. The only expenses the fund has are “other expenses”. What are these, and what part of them are specific to momentum investing? I’m looking at this fund to figure out what the extra work is for momentum investing because you presented it as evidence of higher costs and extra work.

Here’s another way to look at this. Vanguard’s value factor ETF, VFVA, has the identical 0.13% ER. For this fund, Vanguard’s quant team charges one basis point (and “other expenses are 12 basis pts). So far, this evidence doesn’t seem to support the idea that momentum investing is unique in costing more.

Maybe it’s not momentum investing per se, but any style-focused investing that entails extra work? That could explain why the value factor ETF cost as much as the momentum factor ETF.

I tried testing this hypothesis by comparing VFVA with Vanguard’s value index fund. Same factor (a particular style). VTV costs 4 basis points.

So it looks like the 9 basis point difference here (or the 10 basis point difference between VFMO and VOO) isn’t the result of style investing either. Perhaps it is due to actively managed funds being more expensive to operate. Or maybe it’s due to the higher cost of operating new funds. Who knows? (That’s why it would help to know what “other expenses” cover.)

There’s no doubt in my mind that typical momentum investing involves rapid trading and associated high trading costs. Just think Strong Funds. Still, I’m struggling to understand what work beyond high volume trading is intrinsic to momentum investing. Unfortunately, VFMO doesn’t seem to offer any clues.

David Powell
David Powell
2 years ago

Momentum investing = systematic market timing. Not so Humble. 😉

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