This question came from the live room. They said, “Larry, I really enjoyed your book, Your Complete Guide to Factor-Based Investing, where you wrote that momentum has the highest risk-adjusted return of all factors. What would be your exact methodology and portfolio weightings to construct a portfolio that would best take advantage of the momentum factor?”
So first, for our audience, we need to discuss and clarify exactly what we mean by momentum.
There are actually two types of momentum. One is called time-series momentum, and that is simply thought of as “trend.” So, if things are going up, on average they tend to continue to go up for a few more months, and then over the long term, they mean revert.
So, there are very various types of funds that use signals, based upon whether it’s a three-month trend, a six-month signal, one-year long-term reversal, and there’s a whole slew of funds that use different strategies. I will tell you that they all have worked, which is good news because it tells you that evidence is robust to variance definitions and wasn’t some lucky outcome. But it’s also important to understand that there are some periods where the shorter-term signal works best, meaning you’re making a decision based on, say, the last three months versus the last six months or a year. That works best when you get a reversal in markets because you want to unwind your position quickly.
So what happened in, for example, 2008, the markets started going down in 2007, went down all through 2008 into 2009, and then in March, you had this very fast turnaround and the market soared. Well, if you’re waiting for a six-month signal, you’re going to be short the market or not in it when missing that whole rally, a short signal will work better.
But what if you have a market that’s going like this, up and down like this? Then if you have short signals, you’re jumping in and out all of the time. That’s a problem because for the short signals, because you’re going in and out, lots of transactions cause tax implications, and that is not good. A longer signal would work better. The evidence shows that they all work, and what works best is if you do a blend of signals.
The fund we use run by AQR does that, but that means in periods when the short signal did best, it doesn’t do so well. When the long signal does best, there will be funds that do better. We think this is the best fund to give the best odds over the long term—so that’s something to consider.
And what the evidence does show is trend following has helped most just when you need it in prolonged bear markets, because it goes short equities and then they keep going down. So, it would certainly have helped during 2008. It would’ve helped in 2000 to 2002, but then it goes through long periods where doesn’t do so well. So, that’s something, again, you have to think about in your portfolio. You’re buying this as sort of a hedge against bear markets and don’t expect it to add a lot of value for long periods, and then it can really help you when you need it most. So, you don’t want to be looking at it in isolation, but thinking about it in terms of the other portfolio.
There is another kind of momentum called “cross-sectional.” And what that means is it’s looking at relative momentum. So, for example, it might look at, I’ll just use an example, all stocks are going up, but it’s going to buy the stocks that have done the best, the top, say, 10% and short the worst 10% of performance. That, too, works. And we actually use a fund that deals with that strategy, or at least part of it. It is a fund run by AQR and it’s called their risk premium or style premium funds. There are two of them. That’s in the literature. That works well as well. So, that’s the idea on momentum. We do incorporate it, but I think what our investors all should know is the following.
We actually incorporate momentum in our strategies by how we deal with rebalancing. So, what we do is we don’t rebalance until markets make significant moves. Markets actually have to move, say, 20% might be a good number, before we’re going to, say, go in and be buying equities to rebalance the portfolio.
So, what that means it results in if your stocks are 60% of your portfolio, we’re not going to rebalance until it gets to at least 65%, and that takes a big move for that to happen. So, we’re actually allowing momentum to work for you. We’re not rebalancing at 61% or 62%, and, conversely, we’re not buying if equities are doing poorly and you’re dropping from 59% to 58% to 57% to 55%. That is really important to understand. We are using momentum in a way that doesn’t have any trading costs at all. And, in fact, it reduces and minimizes the tax burden from doing so. And all of the funds we use are not index funds, they’re using the knowledge about momentum inside the fund. So let me give you an example of that.
Let’s say you were an investor in Bridgeway, or Dimensional, or Avantis in their small-value fund, and this is not exactly how it works, but we’ll give you the idea. Let’s say it buys small-value stocks and their signal is, or the cross of the point is, the PE has to fall below 10. So, you have this stock, and it’s falling in price, and now the price-earnings ratio goes below 10. And so you would buy it if you’re an index fund that, that was the definition. With Dimensional, Bridgeway, and Avantis, if the price is falling, they won’t buy it even though their signal, their construction methodology, would say to buy it. They won’t buy it until that negative momentum stops, and the price stabilizes for some period. And then they will first start to buy it.
So, they are using this strategy inside, and that is why we think they’re much better vehicles than similar index funds. They’re adding value by using the science. So, hopefully, I’ve answered that question without getting too technical here, but I wanted to give you the way that we do it, and the funds we choose to do it.