Morningstar Advisor - October/November 2012 - (Page 47)

Those exposures don’t reflect management’s views on the relative attractiveness of the market’s sectors, however. AQR Momentum’s portfolio comprises the top third of domestic large- and mid-cap companies as ranked according to their share-price performance during the preceding 12 months. That’s it. If that approach leads to lopsided sector weightings, so be it. The managers won’t bring it back in line. With tech and consumer discretionary stocks pacing the market over the past year, then, it’s not surprising to find those sectors well-represented in the fund’s current portfolio. While momentum’s simplicity is particularly alluring in light of the tactic’s long-term results, it follows, of course, that that strength is of a piece with a central weakness: Investors can quickly find themselves in the wrong place at the wrong time when what was working suddenly stops. Along with that vulnerability to market inflection points, the degree to which the strategy complements other approaches is also problematic, as a history lesson from quant manager Bridgeway Capital Management shows. Play Nice? top-quartile gains in 2010, Bridgeway’s large-growth offering, Bridgeway Large-Cap Growth BRLGX, placed in the category’s bottom third. There are several key differences between Bridgeway and AQR, though. Momentum is just one of several factors in the shop’s models, for example, and price momentum (the variant of the tactic that AQR employs) features in just one of its funds, Bridgeway Small-Cap Momentum BRSMX. The firm places a premium on risk management, too, using models that target, among other things, downside risk, valuation attractiveness, and fundamental health. Amid the flight to risk that began in the first quarter of 2009, those attributes weren’t much in vogue. Lower-quality, speculative fare (which Bridgeway had scant exposure to) led the way instead. For an extended period of time, in fact, the shop’s returns suffered on a relative basis partly because its models successfully identified many companies that, subsequent to a Bridgeway fund purchasing them, went on to exceed Wall Street’s earnings forecast. In some cases, as Bridgeway noted in a shareholder report, the bigger a company’s upside earnings surprise, the worse its stock performed. Momentum and Fundamentals a company’s improving fundamentals. And irrespective of whether Bridgeway’s momentum and fundamental models worked at cross purposes during 2010, the overall result of the shop’s models was a firmwide tilt toward fundamental overachievers, albeit at a time when earnings success wasn’t well-rewarded relative to riskier fare. Chase Growth CHASX—a large-growth fund whose bottom-up, quality-biased managers also use momentum—suffered a fate similar to Bridgeway’s in 2010. The fund boasts a remarkable long-term track record, though. Between 1998 and July 2012, it suffered just 62% of its average rival’s losses in declining markets en route to a total return more than twice the category norm. Similarly, Bridgeway’s oldest offerings— Aggressive Investors I BRAGX and Ultra-Small Company BRUSX, both of which launched in 1994—reside in the sixth and fifth percentiles of their respective categories for the trailing 15-year period through August. For investors, the upshot of both the academic research around momentum and the practice of momentum investing as it has played out at firms like Bridgeway and Chase is that, in order to take advantage of the tactic’s historical tendency to outperform, patience and discipline are required. During some periods, the strategy will be out of favor. In others, gains that can be attributed to momentum may be eroded by losses associated with other strategies. For example, while momentum should do well when growth stocks lead the way, the tactic won’t likely outperform in value-paced markets. Moreover, while there is ample evidence to suggest that momentum can provide a powerful supplement to an investor’s well-diversified portfolio, there are also compelling reasons for skepticism. Blinded by Science? While the long-term profile of this Houstonbased asset manager remains solid, Bridgeway has had a tough time in recent years. That appears to owe at least in part to the more fundamental models it employs alongside the others it uses to construct its funds’ portfolios. Those models steered the shop away from the riskier stocks that enjoyed the most dramatic price appreciation during the rally that began in March 2009. Bridgeway keeps the details of its models under wraps, but it’s known that momentum is among the factors they model. At a glance, that makes the firm’s underperformance in 2010—generally a good one for momentum—surprising: Of the 11 Bridgeway funds that existed during the full year, only two placed in the top half of their respective categories. Yet while the AQR fund delivered If Bridgeway’s experience in 2010 provides a cautionary tale about the way momentum can sometimes interact with more fundamentally focused strategies, other examples indicate that, depending on the market environment it’s deployed within and on investors’ time horizons as well, the tactic can complement such approaches. AQR’s research, for instance, indicates that momentum is negatively correlated with value and, because it has historically generated greater alpha, it pairs better with a portfolio’s allocation to value than does growth. Elsewhere, GMO’s Tom Hancock has argued that share-price momentum anticipates First, while momentum’s track record may look terrific under laboratory conditions, it can be a difficult strategy for investors to exploit. AQR Momentum’s initial investment minimum MorningstarAdvisor.com 47 http://www.MorningstarAdvisor.com

Table of Contents for the Digital Edition of Morningstar Advisor - October/November 2012

Morningstar Advisor - October/November 2012
Contents
Contributors
Letter From the Editor
Ill Communication
Do You Use Factor-Investing Strategies?
Practicing What She Preaches
How to Determine the True Price of ETFs
The Quant Factor
Managers Dispute the Death of Equities
Investments á la Carte
Investment Briefs
Five Inconvenient Truths of Manager Research
Health Care’s Outlook Clarifies
Exploring the World of Factors
Uncloaking the Alpha Machine
Factor Strategies Gain Footholds in Practices
Big Mo
Fitting Factors Into the Formula
Clients Have a Friend in Luther King
Less-Liquid Holdings Mean More-Solid Results
Retirement-Withdrawal Strategies Quantified
Amid Turmoil, Don’t Discount Foreign Equities
Our Favorite Mutual Funds
50 Most-Popular Equity ETFs
Undervalued Stocks With Wide Moats
Should I Stay or Should I Go?

Morningstar Advisor - October/November 2012