Is momentum investing irrational? Momentum here is defined as the persistence of recent pricing trends to continue in the short-term future. It’s not a trick question, but it’s complicated. As financial economics continues to identify “factors” (or alternative betas, if you prefer), the new insight both helps and hinders the effort to clarify the truth about asset pricing. One the one hand, documenting the case that securities prices are driven by more than the “market” beta represents an attack against modern portfolio theory and the efficient market hypothesis. Yet the same smoking guns can also be used to defend EMH. The momentum factor offers an intriguing example.
Let’s step back a bit first and lay out the broader debate about EMH, which is a theory that says all known information is reflected in market prices and so it’s hard to beat the market by picking securities. EMH is crucial piece of MPT, which in its basic form is a body of theories that tells us that the market portfolio—broadly defined—is the “optimal” portfolio. As such, the market portfolio will generate the highest return for a given level of risk over time. The original interpretation of MPT was simply to buy and hold the market portfolio. To the extent you wanted to customize the strategy, you also held some degree of cash. In that case, the only question for managing the total portfolio was how to allocate assets between cash and the market portfolio.
This looked like a prudent strategy for many years, in part because financial research tested MPT and found that the real world results more or less fell in line with what the theory predicted. But starting in the 1980s, economists began turning up so-called anomalies in asset pricing. These anomalies couldn’t be explained by standard finance theory. Among the more widely analyzed examples: the small cap and value factors, which earn higher returns than conventional asset pricing theory allows.
Fast forward to 2010 and it’s clear that financial economics recognizes an array of betas bubbling in the strategic sauce. There are multiple factors determining asset prices instead of just one. That doesn’t mean that the old finance is wrong per se; rather, the new finance is a more detailed, flexible worldview of how capital markets operate. Taken to its logical conclusion, the new interpretation of finance opens up a rainbow of opportunity for designing and managing asset allocation. Investors are no longer limited to deciding on simply allocating between cash and the market portfolio. As financial research has continued to analyze the nuances of markets, it’s uncovered an expanding array of possibilities for customizing investment strategy.
On its face, multiple betas look like a death sentence for MPT and EMH, at least if we’re looking at the original interpretations of these theories. But even then, it’s premature to plan the funeral.
Consider momentum. There’s a small library of research telling us that the momentum effect is durable and worthy of consideration as a separate and distinct beta. In fact, there’s even a trio of momentum index funds from AQR Capital Management that attempt to formally isolate and exploit this factor. But here’s the conundrum:
On the one hand, the presence of momentum confounds and harasses EMH and MPT because this factor isn’t easily explained (if at all) by conventional asset pricing theory. But some of the anti-EMH folks also recommend that momentum is a worthy strategy. In effect, attempting to exploit momentum is rational, or at least reasonable, or so their advice suggests. After all, as alternative betas go, momentum looks compelling. It’s been formally identified in the academic literature for two decades (and pursued by active managers for a lot longer). But while the cat’s out of the bag, momentum still manages to generate alpha, or so we’re told. In fact, momentum is a key source of the enduring success of managed futures-based strategies, which have been around since the 1970s.
The trouble is that exploiting momentum requires a short-term focus, typically no more than a year or two, and more typically less than 12 months. Let’s say that your momentum model is effectively telling you to buy equities because the stock market has been rising sharply in the last 6 months. If we look at investing through momentum-colored glasses, buying equities looks reasonable (rational) under this premise. But let’s also imagine that fundamental market measures, such as dividend yield and price-earnings ratio, are also suggesting that equities are overbought, perhaps to the point that the stock market has reached a point of Irrational Exuberance. Indeed, it’s not unusual to see buy signals based on momentum arise when fundamental valuation measures suggest its time to sell.
Who’s right? The momentum folks? Or the strategists who say that buying stocks at points when valuation is stretched thin is irrational behavior? Both sides are effectively in the anti-EMH camp. And yet each can at times be at odds with one another. What’s a supporter of irrational behavior to do? Who defines irrational decisions?
The problem is that trying to neatly define markets as irrational or rational is a game of semantics. Reality is far more nuanced. Rather than trying to explain asset pricing as a function of rationality or irrationality, it’s more compelling to see markets are driven by an array of betas. Perhaps we can focus on some to develop a strategy to beat the broad market beta. It’s not easy, and if we’re wrong we’ll fall short of the market portfolio, which costs virtually nothing to replicate and requires no skill or talent.
Deciding whether to build portfolios based on multiple betas is a choice. It may or may not be a productive choice. In fact, relatively few who play this game will win, which is why owning the market portfolio still makes sense for many investors. But this much is clear: trying to fit an updated view of asset pricing into yesteryear’s labels only confuses the pursuit of clarity in the capital markets. The old finance isn’t perfect, but it still works pretty good. Unless you aspire to something more.