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A Simple Momentum System for Beating the Market

by: Mebane Faber August 07, 2008 | about stocks: AGG / BND / DBC / DJP / EEM / EFA / GSG / IFGL / IPE / IWM / IYR / RJI / RWX / SPY / TIP / VB / VEU / VNQ / VTI / VWO    
Mebane Faber

Mebane Faber

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Alpha persistence in long short hedge funds. This study gives a lot of support to the upcoming AlphaClone software launch.

This is similar to private equity, where the top funds continue to outperform. Why doesn't this happen in mutual funds? A couple reasons (including index hugging), but the simplest is the capitalism 101 - the $ attracts the best talent.

Now, on to momentum...

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Efficient market theorists have long been puzzled by momentum, and exclaim that it should not be possible to make money from buying past winners and selling past losers in well-functioning markets. Practitioners have been ignoring these efficient market theorists and collecting money for decades. There are probably more academic pieces written on momentum than almost any other subject in finance. (Besides the efficient market hypothesis of course.) I count nearly 900 when searching momentum on the SSRN.

Which is why it makes me shake my head when people talk about how technical analysis doesn't work. It is such an uninformed opinion it is embarrassing at this point. At least three of the Alpha Hall of fame members use technical analysis. I am not defining TA as the subjective form of "charting", but rather the simple analysis of price. Some call it tape reading (Cohen), some call it quant analysis (Simons), and some are fine with the TA label (Jones).

(Disclaimer: Before I start getting loads of hate mail on why technical analysis doesn't work, please realize I do not bow at the altar of any discipline, but am simple guided by what works for me and most importantly what makes money - whether it be value factors like price/book, valued-added fundamental analysis, sentiment analysis, mean reversion techniques, or systematic arb strategies I don't care.)

Fama and French found momentum to be the most predictive of their four factors, and countless other speculators have used momentum as parts of their models. Just about every CTA out there uses momentum under the label trend-following.

One of the most comprehensive studies was performed by Dimson, Marsh, and Staunton of “Triumph of the Optimists” fame. They found that winners (top 20% past returns) beat losers (bottom 20%) by 10.8% per year in the UK equity market from 1956-2007. Even using the top 100 UK stocks by market cap still produced a 7% outperformance. Taking a look at these top 100 stocks since 1900, they found a 10.3% per year outperformance.

For a good overview of the momentum literature check out the appendix in the recent book Smarter Investing in Any Economy: The Definitive Guide to Relative Strength Investing, as well as this listing of papers.

A Long History

Momentum strategies have been in existence for the majority of the 20th Century (and probably longer). Alfred Cowles and Herbert Jones found evidence of momentum as early as the 1930s [1937]. H.M. Gartley [1945] mentions methods of relative strength stock selection in his Financial Analyst’s Journal article “Relative Velocity Statistics: Their Application to Portfolio Analysis.” Robert Levy [1968] identified his own system in “The Relative Strength Concept of Common Stock Price Forecasting”. Other literature penned by investors who suggest using momentum in stock selection include O’Shaughnessy’s [1998] book “What Works on Wall Street”, Martin Zweig’s “Winning on Wall Street”, William O’Neil’s [1988] “How to Make Money in Stocks”, and Nicolas Darvas’s [1960] “How I Made $2,000,000 in the Stock Market.”

One of the best reasons as to why momentum (and by default, indexing) works is the distribution of stock returns. I have a few charts in my book that I think are fantastic, but you will have to wait until that comes out in January.

Cross-Market Momentum (or, relative strength)

I published a paper about a year ago that focused on a very simple trend-following system to reduce risk. The paper could have easily been called "A Quant Approach to Risk Management" as it is really the same thing. However, many investors are not interested in reducing risk, but rather maximizing returns. One could simply leverage the existing system, but with retail rates for margin and cash that is not ideal and will compromise results.

Below we examine a simple cross-market momentum system that stays fully invested at all times. This system compares assets to each other (is real estate going up more than bonds?) rather than my paper which compares assets to themselves (is the S&P going up or down?).

This can also be called a rotation system as you are rotating into what is performing best over a given time period. Many people have researched such systems over fifty years ago and they have continued to work decades after publication.

The system uses the same five asset classes as before - US Stocks, Foreign Stocks, US Bonds, REITs, and Commodities.

Each month, the 3, 6, and 12 month total returns are recorded for each asset class (and then averaged for the combo). The actual time frame selected does not matter much as the 3, 6, and 12 month time frames all produce similar results. I prefer using all three (combo) because it picks the asset classes that are outperforming in numerous time frames.

The investor then simply invests in the top X asset classes for the following month. For example, at the end of 2007 the order of returns from best to worst was Commodities, Foreign Stocks, Bonds, US Stocks, and Real Estate. The portfolio for the next month (January) in 2008 would be in that same order.

Below we show the results of taking the top one, two, and three asset classes, updated monthly, based on the rolling 3,6, and 12-month total returns. (Top 1 means you just take the top asset class each month. Top 2 means you select the top two asset classes each month and put 50% of the portfolio in each, Top 3 is the top three assets with 33% in each, etc).

Click to enlarge

While simply taking the top performing asset class may seem like a good idea because it experiences high returns, in reality it is not. Investing 100% of your portfolio in only one asset class leaves the investor exposed to market shocks, and consequently the turnover, volatility, and drawdowns are higher for a single asset class. A better idea would be to invest in the top 2 or 3 asset classes each month which equates to the top 40-60% of asset classes. (So, traders could run this with 10 asset classes and select the top 50%, or 5 asset classes.) A generic 10 asset class allocation is below (I offer two ETFs in each asset class in case people are utilizing tax harvesting):

US Stocks - VTI, SPY
US Stocks -VB, IWM
Foreign Stocks -VEU, EFA
Foreign Stocks -VWO, EEM
Bonds - IPE, TIP
Bonds - BND, AGG
REITs - VNQ, IYR
REITs - RWX, IFGL
Commodities - DBC, DJP
Commodities - GSG, RJI

For similar risk as buy and hold, taking the top 3 positions for the "combo" outperforms by over 4% per year, with a similar Sharpe Ratio as the timing model. We expect 0.80 to be a consistent target for a momentum approach to tactical asset allocation regardless of the exact strategy employed. This strategy outperforms the buy and hold portfolio about 70% of all years, and 10 of the past 15 years. Taxes are obviously a drag, so it makes the most sense to run this in a tax-deferred account. For those who feel that commissions will be restrictively high, the system could be updated quarterly.

I believe that as humans are involved in the financial markets, the markets will continue to be driven by the emotions of greed and fear. This aspect of the market is a simple example of an alpha generator that is "timeless and universal". Beta asset classes go up about 70% of the time. My research has shown that returns, on average across the five asset classes back to 1973, are about 40% lower and volatility is 20% higher when asset classes are below the 10 month moving average. This “volatility clustering” is one of the simple reasons the timing model works – when markets are declining people become more fearful and use a different part of their brain when markets are going up.

There are many, many variants and offshoots one can take the model. (For example, invest in the top 40% of asset classes and sell one when it drops out of the top 50% to reduce turnover.) For the most part, the take away is that for similar risk, a momentum model generates some excess annual returns. This is not the investing Holy Grail, but I consider this a method for a simple, timeless alpha that is rooted in human psychology.

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This article has 12 comments:

  •  
    Aug 07 05:51 PM
    Like many other discussions of momentum analysis, this article makes broad assertions of the virtues while skirting the difficult details. Of course momentum exists in individual stocks – few people subscribe to the pure form of the random walk.

    The underlying economic principles are readily understandable. For a single company, steady earnings growth over the past few quarters is in most instances the result of circumstances that won’t change on a dime, so, all other factors being equal, betting on a continuation of a good trend is better than betting on the reversal of a series of bad quarters. An ETF approach is simply the single company approach applied to a sector.

    The difficult details are the choice of entry and exit points. Most trends are interrupted by breaks, and all eventually reverse. All momentum-investing systems rely upon rules that purport to filter out the noise, cut the losses, hang in through the head-fake breaks, and exit before the true reversal, rolling the investment into another stock’s uptrend.

    Most such systems will make some money some of the time. If any system exists that makes good money all of the time, its inventor isn’t going to be writing a book about it.
    Reply
  •  
    Aug 07 08:04 PM
    Those are all ex-post analysis, aren't they? Comparing winners to loosers afterwards for sure shows an outperformance ;)

    You didn't reveal any scientific proof because you can't.

    cheers
    rudi
    Reply
  •  
    Aug 07 08:24 PM
    Investment and trading is part art and part science. Momentum system as broadly defined here is definitely a mainstream strategy which many have benefited from, just as many have benefited from the Warren Buffet buy and hold strategy. Each strategy has strong points and drawbacks, but momentum strategy calls for control of risk [stop loss] and locking in profits [sell stop]; these are important features which many find appealing and practical.
    Reply
  •  
    Aug 07 09:00 PM
    There can be long periods when markets are not trending and price keeps crossing above and below the 10-month (or whatever) moving average one is using to buy or sell. For example, if I were using PCRIX as my commodity investment there were two buy-sell round trips in 2005 and four round trips in 2006 which ground out loss after loss. I wouldn't have been able to stay with it over that 2 year period - would you?
    Reply
  •  
    Aug 08 12:29 AM
    Puddi said: "Most such systems will make some money some of the time. If any system exists that makes good money all of the time, its inventor isn’t going to be writing a book about it."

    No trading system purports to make money all of the time. In fact, you can have less than 50% winning trades and can still make money. I suggest you read up on some basic trading theory.

    Rudi said: "You didn't reveal any scientific proof because you can't."

    Ah, dude first chill and then look at his peer-reviewed published academic paper! This is one of the most documented, pervasive effects in finance and you guys act like Mr. Faber is some kinda snake-oil salesman!!

    Mebane, maybe these comments are an indicator as to why the momentum effect keeps on working....

    Cheers from Osaka,
    john
    Reply
  •  
    Aug 08 01:18 AM
    Excellent article. Thanks very much.
    Reply
  •  
    Aug 08 01:42 AM
    Price is a reflection of value. The value of an asset is equal to the total of all future earnings, such as dividends, which will be obtained from it, discounted for the interest that will be lost from having to wait to get these earnings. That said, Mr. Faber, kindly run this computation in Mathematica.

    ListLinePlot[Accumulat...

    Prove to me that what we see in the markets is not, in fact, the above in disguise. Until then, I couldn't care less about your rotation/momentum system (or your book, for that matter).
    Reply
  •  
    Aug 08 07:33 AM
    Ikkyu:
    Ok I read the paper a second time:

    If you assume a daily standard deviation of say 1%, then you get an approximate standard deviation (ignoring fat tails, using a hundret years, etc.) of sqrt(1*250*100) = 158%. If you would like to do a simple test you would compare the difference of both charts (Exhibit 2 and 3) to twice that standarddeviation. The cumulated returns of the traded series shoud be 300% larger than the buy and hold strategy to be 95% sure, not to have an incidental phenomenon.

    To get the mentioned "scientific proof", a lot more would be neccesary. One thing that did never happen is a test of the hypothesis on true validation data. i.e. you apply an (appropriate) econometric test to data, that you never used for your analysis and which you don't use a second time!

    "you guys act like Mr. Faber is some kinda snake-oil salesman!! "
    Exactly. Because he does marketing for his book and he is unscientific.

    I bet he would never put all his money in that strategy and lever. Neither would he (and wouldn't be able to) administer larger sums of money with that strategy.

    I am very willing to discuss this further, if it helps to clarify!
    Reply
  •  
    Aug 08 08:09 AM
    as far as i can tell there is sector and asset class rotation ata speed and with a power like never before. Imho this is precisely the to be expected effect of myriads of dumb quant funds chasing more or less the same momentum strategies. Since they follow price, not value they tend to actually hunt their own echos if they exercise a sufficiently large influence over the market. it seems to me, that this stage has arrived. so they rotate out of oil and oil stocks and out of solar into biotech and financials - producing a rapid price deline of the former and a rapid price jump for the latter. If both trends have gone far enough they will move on to the next sectors and assets. In the process, a growing market weight of that will tend to ever more shorten these cycles until they occur on weekly rather than multi-month cycles. Finally the speed at which the portfolios can be turned over will act as a natural border. When all is said and done though, longterm stock prices will rise nor faster or slower than without these momentum folks. But there will be a heck of volatility around the mean.
    What's my take? I gladly look out for value opportunities created by the brainless stampede of the momentum herd. They can chase the pennies (dwindling excess returns versus broad indexes of 2-3 percent per annum) while i will look to make the bucks (5-10%) outperformance on average.
    Reply
  •  
    Aug 08 08:45 AM
    Clearly Graham and Ken Fisher have been some of the most successful investors and both somehow managed to find time to write books while Fisher also has many peer reviewed papers published.

    The buy and hold arguement holds because eventually most stocks rise, and if you wait long enough your selections will as well. Combining sector rotation with long term objectives has been a hallmark of success for many long term holders thought of as buy and hold, the rotation is just slower for some people (Buffett) than others (Fisher). And some are much faster (Town).

    It is not possible to copy Buffett's returns without copying his methodology, and that includes being an active manager, whether a a board member at Washington Post and Coke, or through selecting and retaining the management of the wholy owned companies.

    Naturally all analysis is post, as are all back-testing analysis. You obviously can't analyze what hasn't happened, so that arguement seem disingenuous.

    The risk is chasing old returns, so balancing over trading with getting in after the momentum has changed requires more thought. A less risky model may be to take benchmark risk against a market cap based world index like MSCI World by varying up or down the allocation of the sectors.

    One thing missing is industry rotation in the article. Those that rotated out of retail, homebuilders, discretionary and autos last summer are and will likely continue to do well.

    Matt
    Reply
  •  
    Aug 08 10:25 AM
    Besides the 8-9% that stock markets make, one can only win what others loose. So who are the loosers when everybody outperformes by 10%?

    This is what EMH supporters tell hard cases.

    Matt:
    "Naturally all analysis is post"
    You can develop a strategy with old data, say 1900 to 1980, and then validate the strategy with the data from 1980 until today. There are still some difficulties with that but you test the model on data which you didn't use to build the model, thats essential.
    I can't believe I answered that seriously.

    If you guys like, we can do an experiment, just say: "I'd like to".

    cheers
    rudi
    Reply
  •  
    Aug 09 04:16 PM
    Agree with the statemen investing is part art and part science. 3 members of my free website are u this year with over 95% success rates on more than 250 investments cumulative. Making the trend your friend is certainly a key concept as the author states. Key is knowing the right stocks at the right prices
    Reply
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