5 Questions For Wesley Gray, AlphaArchitect.com

Momentum investing – betting on the persistence of price trends in the short to medium term — has captured the crowd’s attention in recent years. Consider, for instance, the strong growth in ETF assets in the niche. The first fund launched a bit more than five years ago; today, there are dozens of momentum ETFs, collectively holding nearly $15 billion in assets, according to etfdb.com. That’s still a small piece of the total ETF pie, but the strategy’s allure could keep growth bubbling for years to come. What should investors expect? Does the rising interest in momentum raise concerns about the strategy’s expected return? For some insight, The Capital Spectator asked Wesley Gray at Alpha Architect, a wealth manager near Philadelphia. Gray, who previously worked as a finance professor, is an obvious source for discussing momentum. In addition to managing variations of momentum-based portfolios for clients, he and his team have written extensively about the strategy at AlphaArchitect.com, a popular investing blog. Gray is also the co-author of Quantitative Momentum: A Practitioner’s Guide to Building a Momentum-Based Stock Selection System

Why does momentum persist? It’s been identified in the literature for decades and traders have been using it for much longer in one form or another. Most return anomalies are arbitraged away or turn out to be data-mining illusions. Momentum seems to be different. Why?

​This is a debate that still rages in academic circles, but it boils down to a mix of fundamental risk and mispricing that is tough to arbitrage away. Fundamental risk is easy to understand — higher risk generally earns higher returns in a competitive equilibrium. Mispricing is a bit trickier.

If the mispricing is easy to exploit — i.e., you can generate 2-plus Sharpe ratio strategies by exploiting momentum — one can be sure the highly leveraged computer geeks at fast-moving hedge funds and proprietary trading shops will take care of the mispricing. But what if trying to exploit momentum mispricing is akin to eating a hand grenade on occasion? Well, it turns out that strategies designed to “arbitrage” momentum profits away can be incredibly volatile and suffer huge drawdowns — not exactly low-risk-easy-to-leverage trading strategies that the 200 IQ types look forward to exploiting.

Long story short, sometimes even the best evidence-based active investment strategies can create a formidable challenge to investors seeking to exploit them. It’s a kind of quid pro quo: in order to access the potential gain, you must willing to accept the potential pain.

Could momentum be the most epic data-mining result in all of finance? Sure. Could it vanish in the future? Possible. However, if we believe that momentum stocks are 1) naturally riskier and 2) driven by systematic mispricing that is costly to “arbitrage,” we can expect momentum investing to work in the future.1

There’s been strong growth in momentum-focused strategies and investment products in recent years. Is there a capacity limit for the strategy? If so, are we near that limit?

Jack Vogel, one of my business partners, recently published a long piece called, “Factor Investing and Trading Costs,” which addresses this question in great detail. The short answer, yes, the capacity on momentum strategies is limited. Some folks argue it’s anywhere from $5 billion to $300 billion-plus in capacity.

On the question of “are we near the limit,” I’d guess that we are still a ways off, based on a few things. First, most so-called momentum funds are closet-indexers so their actual momentum exposure if fairly limited even with a large amount of assets under management. Also, David Blitz [Robeco Asset Management] highlights that the ETF market as a whole hasn’t taken a dramatic momentum bet.

At some point momentum, or any strategy for that matter, could suffer from too many dollars chasing too few returns. That said, given the relatively poor performance of momentum over the past decade, I’m not convinced there are huge swaths of short-term-performance-chasing investors looking to dive into stock momentum strategies — I think most [performance-chasing] investors have turned to things like cryptocurrency speculation.

You’ve previously noted that institutional investors have only dipped their toes into momentum. That’s surprising, given the strategy’s encouraging historical record. What accounts for the reluctance among the investment behemoths to dive in deeper?

​There are almost certainly some large institutional investors implementing uber-sophisticated momentum strategies at scale. However, I’ve spoken to chief investment officers at several multi-billion-dollar endowments who weren’t even familiar with the term and/or the strategy. This was really surprising when I engaged in one of these conversations, but then I quickly remembered that not every CIO is buried in academic finance research. Many CIOs are tried and true fundamental investors and their philosophies revolve around the “value investing” ethos.

So, even in this day and age, when systematic strategies are en vogue in the ETF space, many in the institutional space are still enamored with human stock pickers as opposed to fairly simple systematic investment approaches. I’m not exactly sure why this is the case, but my guess is that there is a potential agency problem at play: the consultants and internal investment staffs wouldn’t have a job if the pension/endowment bought a handful of index or factor funds and called it a day.​

Are momentum strategies sufficiently robust to stand on their own? Or is it advisable to pair it with other strategies, such as value investing and/or a plain-vanilla market-indexing portfolio?

​Depends who you ask. If you ask a value investor they will say, “buy value,” and never touch momentum, and vice versa for a momentum/technical type.

The answer is you should probably do both, because value and momentum are excellent diversifiers. AQR Capital Management published an excellent paper [“Value and Momentum Everywhere”] on the subject.

Why do so many investors punt on momentum strategies? We wrote a piece, “Evidence-based investing requires less religion and more reason,” where we discuss the fundamental and technical religions in the marketplace. We think a lot of the “anti-momentum” sentiment is driven by a religious-like approach to investing. But why?

Taking a step back, the mission for long-term active investors is to beat the market. Active investors should focus on the scientific method to address a basic question: What works? Warren Buffett obviously showed that value investing, irrespective of technical considerations, can work. But George Soros and Paul Tudor Jones also showed that technical analysis can work just as well. 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. Many dogmatic investors, however, looking to confirm what they already believe, selectively adopt the research evidence that fits their investing religion.

In contrast, an evidence-based investor will conclude that fundamental and technical analysis strategies can work because they are two sides of the same coin. They are cousins because they share the common objective of exploiting the poor decisions of market participants influenced by biased decision-making.

As Andrew Lo, an influential and forward-looking financial economist at MIT, correctly observes about the debate between fundamental and technical traders, “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.”

What’s the biggest risk with momentum investing generally? Is there some aspect of risk that’s unique to momentum?

​Volatility. For example, our public momentum indexes (see the data on our indexes here), are highly focused and concentrated long-only momentum strategies. These strategies are expected to have around 25% volatility versus 15% for the generic stock market. That’s intense!

You’ll almost certainly experience violent portfolio pain so that you’ll wish you had never heard of momentum investing. But, of course, this intense volatility arguably comes with a reasonable chance of earning excess returns.​ One can apply trend-following overlays and other risk management strategies to try and ease the momentum pain, but the harsh reality is that volatility will always exist for well-constructed momentum strategies.

There are some other risks associated with long/short momentum strategies, which are related to dynamically shifting beta. If one is going down that path they should certainly read “Momentum Crashes,” by Kent Daniel and Tobias Moskowitz.

1 For defining momentum, Gray notes: “Momentum can refer to trend-following strategies, also called ‘time series’ momentum, but let’s discuss the classic ‘momentum factor’ in academic finance research. This momentum is a relative strength, or ‘cross-sectional,’ momentum (described here). Quick example to highlight the difference: Consider stock A and B. A is down 10% and B is down 20% over the past 12 months. A trend-following, or time series momentum, strategy would not buy either of these stocks, however, a cross-sectional momentum strategy would buy A and short/avoid B, because A is relatively stronger than B, despite having poor absolute momentum.”