Momentum investing gains momentum

Strategy could replace growth to complement value in portfolios, Morningstar analyst says

May 7, 2013 @ 12:01 am

By Jason Kephart

Momentum investing is starting to pick up steam, which means that it is time to rethink the role that growth stocks play in a portfolio.

Growth stocks traditionally have been combined with value stocks in a portfolio, but research suggests a momentum strategy may actually pair better with a value strategy.

A portfolio of 50% allocated to the Russell 1000 Value Index and 50% to the AQR Momentum Index would have beat a half-growth and half-value portfolio by about 20% over the 10-year period ended Dec. 31, without adding any extra volatility, according to Morningstar.

“If you just combine value and growth, you're neutralizing your value bet,” said Samuel Lee, an exchange-traded-fund analyst at Morningstar Inc.

Value and momentum, which typically invests in the best-performing stocks over the previous 12 months, complement each other well for a couple of reasons.

For one, momentum has proven itself to be a source of high returns over many different time periods and asset classes.

“Momentum is one of the most powerful patterns that exist in markets,” Mr. Lee said. “It's been found in almost every single market, from commodities to bonds to even Victorian-era stocks.”

Momentum investing is a way for investors to take advantage of the naturally occurring phenomena.

“It's a systematic way to exploit the fact that humans chase performance,” Mr. Lee said.

“Everyone knows performance chasing is bad, and everyone knows everyone does it,” he said. “Momentum investing is a disciplined way of taking advantage of that irrational behavior.”

Value and momentum also work best over different time horizons.

Value is about exploiting pessimism over the long term, whereas momentum is about exploiting optimism over the short term, Mr. Lee said.

The biggest challenge that momentum strategies have faced so far is that they still are relatively unknown outside institutional investing and there are only a handful of funds designed to offer exposure to them.

AQR Capital Management, one of the leaders in momentum-investing research, launched the first, and only, three momentum-focused mutual funds in 2009. Combined they have just over $1 billion in assets.

Russell Investments launched the first momentum ETFs in 2011, but they were shut down after Russell decided to exit the ETF business.

BlackRock Inc. is the latest fund company to give momentum investing a hand. It launched the iShares MSCI USA Momentum Factor ETF last month.

“I think it's probably the most credible momentum ETF to come out to-date,” Mr. Lee said.

He highlighted the ETF's low costs — it charges 15 basis points — and its use of both 12-month returns and six-month returns as its best features.

“When you blend them together, it enhances consistency,” Mr. Lee said.

The lack of popularity for momentum strategies could be a good thing.

“If everyone suddenly bought momentum funds, they would no longer work,” Mr. Lee said.

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