I recently wrote on stockcharts.com that of the four iShares MSCI factor ETFs, Value and Momentum were breaking out, while Size and Quality were not. This caught my eye after reading the book Quantitative Momentum: A Practitioner's Guide to Building a Momentum-Based Stock Selection System by Wes Gray and Jack Vogel.
This was a fantastic read with two main sections. The first part explains how we arrived at the momentum factor over time and why it has a place in active management. The second section describes how to create a momentum model and provides excellent backtest results on various iterations.
I believe Chapter 1 should be required reading for anyone in the financial industry. They explain how technical analysis was the first form of financial analysis, a point made very well by Barry Sine, Drexel Hamilton at the MTA Symposium a few years back. While fundamental analysis may be seen as more intellectually rigorous than technical analysis, they ask, "But in the end, does effort and sophistication really matter?"
“Avoid intense ideology because it ruins your mind.”
It's worth noting that Gray and Vogel repeatedly suggest avoiding following any one strategy or discipline religiously. Quotes from Andrew Lo ("In the end, we all have the same goal, which is to forecast uncertain market prices. We should be able to learn from each other.") and Charlie Munger ("Avoid extremely intense ideology because it ruins your mind.") certainly back up that opinion.
They essentially advocate combining fundamental and technical tools using quantitative methods. Indeed, they have the research citations to back up statements like this:
An ever-growing body of academic research formalizes the evidence that fundamental strategies (e.g., value and quality) and technical strategies (e.g., momentum and trend-following) both seem to work.
In light of the raging active vs. passive debate, Chapter 2 should be required reading as well. They make a case for why active management should work, as long as active management is truly active. This means smaller, more concentrated portfolios with higher tracking error and higher active share, as I pointed out in my latest discussion on the topic.
So why should active management work? Because of behavioral finance, as they explain in this simple formula:
Behavioral Bias + Market Friction = Mispriced Assets
They also do a great job highlighting the challenges for active management. First, we have what Michael Mauboussin calls the "Paradox of Skill." Basically, less skilled managers exit the industry, which leaves more skilled managers and a higher level of competition. Or as they put it, "An active investor is still only one shark in a tank filled with other sharks. All sharks are smart..."
Second, behavioral finance itself has limitations. Just because investors behave irrationally does not mean you can necessarily profit from it. "Behavioral Finance can explain why we observe inefficient market prices and why we observe that most active managers can't beat the market."
So how do you win as an active investor? They use a poker table analogy. When you sit down, you want to know the worst player (so you can take advantage of their poor decisions) but you also want to know the best player (so you can take advantage of their constraints and limitations). Patrick O'Shaughnessy dug deeper into this topic (and many others) with Wes Gray on his Invest Like the Best podcast. Highly recommend.
Gray and Vogel do a fantastic job explaining what momentum is, and more importantly, what it is not. They explain the differences between momentum and growth, which many investors love to confuse. Basically, growth is characterized by high prices relative to past fundamentals (for example, P/E, Price to Book, etc.) while momentum is essentially the strength in price relative to itself.
“Buy cheap; buy strong; hold ‘em long.”
As they demonstrate, the 52-week high list tends to outperform the 52-week low list. And when you combine this sort of momentum approach with a value discipline, you have a recipe for long-term success.
As they spell out how to construct a momentum model in the second half of the book, they are very up front about the challenges of following a momentum strategy. To summarize, it's not for everyone.
Momentum models tend to have much higher drawdowns than the market average, meaning you need to have a stomach of steel to weather frequent down periods. But the overall strong relative results mean it's worth considering how you can incorporate momentum into your thinking.
Overall, this was a fantastic read by some accomplished investors. They highlight the gap between what the financial industry actually does and what the data suggests it should do. Investors that recognize this gap and adapt their processes stand to profit the most!
RR#6,
Dave
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