Morningstar - Q4 2020 - 58

Strategies

Momentum Often Loses Steam in Practice
Sound in theory, momentum gets lost in
translation when run by funds.
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Estimating the End (of Retirement)

RESEARCH

Alex Bryan

Quant U

Solving the Asset-Location Problem, Part II
Best Ideas

Manager: A Standout Approach
Passive: Risk Tamer	
Equity: Growing Abroad

Momentum investing is sound in theory but
often disappoints in practice. This strategy
is based on the tendency for recent performance
to persist in the short term. On paper, simple
momentum strategies that target stocks
with strong returns over the past year seem to
work well. But they ignore real-world frictions,
like trading costs and taxes, and often
look quite different from momentum funds that
investors can buy.
While momentum has continued to work
on paper in recent years, most broad large- and
mid-cap U.S. momentum funds have
underperformed the Russell 1000 Growth Index.
(This is an appropriate benchmark because
most momentum funds have a growth tilt.) And
though few of these funds have been
around for a decade, none has managed to beat
that benchmark over that horizon.
Momentum investing can succeed in
practice, but portfolio construction choices and
fees matter-a lot. The best funds balance
transaction costs against momentum style
purity, effectively capture the momentum effect
documented in academic literature, and
consider risk.
A Promising Idea
At first blush, momentum investing may seem
foolish. It ignores fundamental data,
valuations, and warnings that past returns aren't

indicative of the future. Most momentum
strategies rely entirely on recent performance to
select investments, which is antithetical to
fundamental-value and passive index investing.
Yet momentum has been widely documented in
academic literature, showing up in all asset
classes and in most markets. The best explanation
for this effect is that investors are slow to react
to new information, causing prices to adjust more
slowly than they should.
EXHIB IT 1 illustrates the theoretical payoff of
a long-short momentum strategy among
the largest quintile of U.S. stocks, similar to the
size orientation of the Russell 1000 Index.
Each month, the strategy goes long the quintile
of stocks from that group with the highest
returns over the past 12 months (excluding the
most recent one), weighted by market
capitalization, and shorts the quintile with the
lowest returns over that period.

This would have been a successful, albeit risky,
strategy. From the end of October 2000
through June 2020, this strategy would have
returned 2.43% annually before transaction
costs.1 As this is a long-short strategy, a positive
return like this is a success.
That said, this momentum strategy experienced
severe losses when the market rebounded in 2009.
During that time, stocks with the worst returns
over the past year rebounded the most, hurting
momentum. Of course, most investors can't
stomach this level of risk, ignore transaction costs,
or short stocks. Thus, momentum funds on the

1 This period is after Regulation Fair Disclosure went into effect, which prohibits selective disclosure of material information.

58

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Morningstar - Q4 2020

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Morningstar - Q4 2020 - Cover1
Morningstar - Q4 2020 - Cover2
Morningstar - Q4 2020 - 1
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Morningstar - Q4 2020 - Contents
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