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Momentum: The Trend Is Your Friend

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Callan's director of Hedge Fund Research, Jim McKee, explores the advantages of momentum-based investing strategies, which profit from market trends in whichever direction. He discusses the rationale behind them, how they are defined and harnessed for different diversification needs, and whether they are appropriate for fund sponsors.

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Momentum: The Trend Is Your Friend

  1. 1. Knowledge. Experience. Integrity. Jim McKee is the director of Callan’s Hedge Fund Research group. He specializes in hedge fund research addressing related issues of asset allocation, manager structure, manager search, and performance evaluation for Callan’s institutional clients. CALLAN INSTITUTE Research October 2016 Momentum The Trend Is Your Friend With investors facing divergent scenarios of inflation or recession in which prices of all assets can go in radically new directions, now may be the time to consider momentum-based strategies. These approaches profit from distinct trends—in whichever direction—and reflect the reality that fear and greed fuel herding behavior by investors. Academic research has shown that trend-following strategies can complement a balanced portfolio of stocks and bonds. This essay was originally published in the second quarter 2016 edition of Hedge Fund Monitor.
  2. 2. 2 ‘Houston, We’ve Had a Problem Here’ On April 13, 1970, two days after Apollo 13’s lift-off, the spacecraft’s oxygen tank exploded 200,000 miles from Earth. Lacking enough power to land on the moon and return home, the crew focused on returning to Earth safely. After a sling shot around the moon propelled by its gravitational force, the crippled Apollo 13 could only tweak its trajectory toward Earth while hoping for a soft landing. Too shallow a path into the Earth’s atmosphere would carry it off into infinite space. Too sharp a path would burn up the helpless vessel. As fate played its card, Apollo 13 fell safely into the ocean, avoiding the unpleasant alternatives of a fiery finish or endless purgatory.1 Today, the world’s central bankers face a similar, albeit less dramatic, dilemma. Over the last 35 years, they have had plenty of fuel from lowering interest rates to keep economies aloft while avoiding hard landings. With rates at zero, more or less, these central bankers have lost their conventional power to lift their economies, which are at risk of stalling. Their remaining levers of “quantitative easing” and other risk-promoting tools can tweak economic trajectories, but only on the margin. If central banks ease conditions too much, an economy can slide helplessly toward potentially unstoppa- ble inflation, like Zimbabwe in 2008. If too little, the economy can experience a hard landing, like Greece today. With just the right policies to make sure economic growth outpaces debt growth, a safe landing is possible. However, the margin of error for policy makers between the socially destabilizing fates of a hard landing and inflation has never been tighter. “If you’re going through hell, keep going.” – Winston Churchill Get Your Mojo Workin’ A sense of increasing uncertainty looms for investors facing these divergent scenarios of inflation and recession. If policy makers are unable to steer clear of recession, stock investors will likely suffer steep losses. If the central bank printing press runs too fast, bond holders will face tremendous losses when interest rates spike. If consumer demand fails to respond sufficiently to further stimulus stoked by the printing press, stocks will likely reverse their long trend up from their last cyclical bottom in 2009. Given this environment, investors face a prospective inflection point in which prices of all assets can go in radically new directions. Consequently, today is a good time to consider momentum-based strategies that profit from distinct trends in whichever direction, particularly when long-only investments are at risk of fall- ing. In this paper, we look at the rationale behind these approaches, how they are defined and harnessed for different diversification needs, and whether they are appropriate for fund sponsors. “Trends that can’t continue won’t.” – Herbert Stein 1 Apollo Expeditions to the Moon, ed. Edgar M. Cortright. Washington, D.C.: National Aeronautics and Space Administration, 1975, p. 245-263. The margin of error for policy makers between the socially destabilizing fates of a hard landing and inflation has never been tighter.
  3. 3. 3Knowledge. Experience. Integrity. Momentum as a Risk Premium When momentum is in your favor, it is a beautiful thing. Unlike long-only stocks or bonds, it is not beholden to any economic forecast. The investment rationale behind momentum strategies and their durability as a positive risk premium has many supporting arguments. While efficient market theory argues that market prices reflect all known information instantly, in reality fear and greed fuel herding behavior by investors. First, investors typically underreact to new information affecting market prices. As that new information gets assimilated by the market, prices tend to trend further as more investors buy into the story. Investors’ behavioral shortcomings, such as confirmation bias, help to support these trending behaviors in market prices. Seasonal events, such as tax-related selling when investors prune losing positions to generate a realized loss, can reinforce trending patterns. The final phase of a mar- ket trend reflects a delayed overreaction in which prevailing investor sentiment pushes prices past fair underlying value, setting the stage for a trend’s reversal. When market equilibrium shifts in the wake of new information or in the transition from one economic cycle to another, the rules-based process behind momentum strategies responds to the new direction in an unbiased manner. The excess returns of trend-following over cash are particularly attractive during periods of market volatility and shifting economic cycles. The high trading activity needed to execute a trend-following strategy, though, demands an efficient, disciplined implementation process. As with any investment strategy, an attractive op- portunity burdened by excessive management fees and transaction costs can quickly become unattractive. “Often the only difference between winning and losing is momentum.” – John C. Maxwell The Choice Is Yours Price-based momentum strategies take two distinct formats serving different investment objectives. Giv- en the often uncorrelated behavior of trend-following with long-only investments, they are compelling diversifiers beside an existing stock and bond portfolio. • Price Momentum: This strategy is focused on capturing nominal price trends across liquid markets (i.e., stocks, bonds, currencies, commodities). Many studies document the positive excess returns from this strategy,2 including one from 1990.3 Whether long or short, the strategy’s underlying components are directionally exposed to market beta. The key to creating attractive risk-adjusted excess returns is diversification across dozens or hundreds of markets, each sized for its respective risk contribution. The time frames for targeting trends can be short (e.g., one month), medium (three months), long (12 months), or a combination.4 This strategy uses liquid index-derivative contracts (e.g., equity futures, bond futures, currency forwards, and commodity futures). If a market’s trend signal is strong, the strat- egy adds that market’s exposure, whether long or short. In markets with declining price trends, this strategy normally has a negative correlation with equity risk and consequently tends to add value to 2 Tobias J. Moskowitz, “Time Series Momentum.” Journal of Financial Economics. Volume 104, Issue 2, May 2012, pp. 228-250. (http://www.sciencedirect.com/science/article/pii/S0304405X11002613) 3 Narasimhan Jegadeesh, “Evidence of Predictable Behavior of Security Returns.” The Journal of Finance. Volume 45, Issue 3, July 1990, pp. 881-898. (http://m.e-m-h.org/Jega90.pdf) 4 Price movements within shorter time frames can involve more statistical noise and fewer signals, therefore making them less attrac- tive for trend-following strategies. Time frames longer than one year do not adjust frequently enough to capture trends or provide the desired diversifying benefits compared to a traditional buy-and-hold portfolio. The excess returns of trend-following over cash are particularly attractive during periods of market volatility and shifting eco- nomic cycles.
  4. 4. 4 the total portfolio. In markets trending up, the strategy’s correlation tends to be positive while its returns remain additive. However, in flat or range-bound markets, trend-following strategies tend to lose their value-added purpose. • Spread Momentum: Unlike price momentum, the spread momentum approach seeks to capture the momentum risk factor between related securities or asset classes. For example, when ranked by degrees of momentum exposure over short, medium, and long time frames, securities exhibiting the most momen- tum are held long while those with the least are held short. In contrast to the price momentum strategy, the spread momentum strategy excludes explicit beta or market risk. Various studies5 have documented evidence of positive excess returns from this strategy. Since this specific risk exposure hedges out the broad market’s volatility, this strategy may use leverage to amplify its returns. However, sudden reversals of securities with relatively attractive momentum characteristics can be painful and occur at the same time as market-related reversals. Meanwhile, other style risk factors, such as value or defensive, are likely to perform well with lower or even negative correlation to momentum. Given this statistical relationship, which is also true for price momentum, this strategy can be a more effective diversifier when an investor’s total portfolio has already reached the limits of its market risk budget. Another “momentum” approach based on underlying fundamental factors warrants a comment. Funda- mental momentum focuses on trends, positive or negative, in earnings, sales, or other metrics of corpo- rate or economic growth. Like price momentum, the premise behind this strategy is the belief that inves- tors initially underreact to changes in fundamental metrics. Subsequently confirmed fundamentals lead more investors to adopt that security’s narrative. As the trending fundamentals pick up more followers, the trend climaxes with future earnings forecasts that are too pessimistic or optimistic. The performance pattern of this strategy correlates with factors used for selecting growth-oriented stocks. Given that funda- mental momentum is a highly subjective measure compared to price-based momentum and is influenced more by economic or sales cycles, it has a less significant role in most trend-following applications. “In investing, what is comfortable is rarely profitable.” – Robert Arnott When a Trend Goes Out of Style Like any fashion trend that reaches its final stage of popularity, an overcrowded trade with no new converts behind it will encounter resistance and reverse direction. Such reversals can be sudden and not tied to new information. Since these dislocations are so unpredictable, trend-following strategies are vulnerable to sud- den bouts of volatility. While volatility is important to keep trends in motion, too much of it can destabilize any established trend. As George Soros noted, “When a long-term trend loses its momentum, short-term volatility tends to rise. It is easy to see why that should be so: the trend-following crowd is disoriented.” Sudden market reversals, such as those in March 2009, can be costly to trend-followers, but they become part of the next signal to reverse positions or at least be neutral. This constant need to adapt is why ac- tive risk management plays a significant role for momentum-based strategies, in contrast to buy-and-hold strategies. Systematically cutting losers while letting winners ride is the essence behind success in cap- turing the risk premium from momentum strategies. When trends disappear and uncertainty increases, risk exposures need to be pulled down until market signals overcome noise. 5 Clifford Asness, Andrea Frazzini, Ronen Israel, and Tobias Moskowitz, “Fact, Fiction and Momentum Investing.” Journal of Portfolio Management, Volume 40, No. 5, Fall 2014, pp. 75-92. (www.aqr.com/library/journal-articles/fact-fiction-and-momentum-investing) Trend-following strategies are vulnerable to sudden bouts of volatility.
  5. 5. 5Knowledge. Experience. Integrity. In addition to sudden inflection points that reverse a trend, a market with no discernable trend threatens any trend-follower’s success. Range-bound markets typically create high turnover of market exposures, long and short, as trend-following models unproductively cycle in and out of positions. Such high turnover involves more trading losses and operating expenses. For those inevitable spells of trendless markets, managers of trend-following strategies add diversifica- tion strategies such as mean-reversion, carry or other value-oriented techniques to generate incremental profits. Such extra exposures together with momentum give the combined investment strategy a more attractive risk-adjusted profile as a standalone product. These added diversifiers may have less strategy capacity or require more proprietary research than rules-based momentum and therefore cost more. In some instances, these diversifiers with low correlation to momentum risk are correlated with similar risk factors elsewhere in the fund sponsor’s portfolio, like value-oriented stocks and income-generating bonds, as well as any active rebalancing program. Consequently, investors who have well-diversified fac- tor exposures elsewhere to complement momentum risk and can accept the long-term cyclical patterns of undiversified momentum risk may be better served by a pure trend-following strategy. This is especially true if it can be implemented at a lower cost. “Trendy is the last stage before tacky.” – Karl Lagerfeld Diversity Is Good for Business Investing based on price trends is contrary to the core beliefs of many value investors. However, even Warren Buffett would be hard-pressed today to find any meaningful assets selling at an attractive dis- count, as prospective returns for stocks, bonds, and other cash-generating assets are in the mid-single digits, at best. While Buffett is famous for claiming to “be fearful when others are greedy and greedy when others are fearful,” what does one do when markets are moving between these emotional extremes? Trend-following strategies help to complement a balanced portfolio of stocks and bonds. To illustrate performance for price momentum strategies, we used three peer group index proxies: Cred- it Suisse Managed Futures Index, BarclayHedge BTOP50 Index, and SocGen Trend Index (formerly Newedge Trend Index). These are not pure expressions of the strategies, given the typical manager’s propensity to add other diversifying approaches, but trend-following is a substantial component of each index’s returns. The correlation of these trend-following indices with the S&P 500 over rolling three-year periods ranges between -0.5 and +0.7 (Exhibit 1). Notably, these indices have typically been rising when stocks were falling. But trend-following strategies should not be considered as explicit portfolio hedges. Rather, they are sim- ply an additional source of uncorrelated returns. Although trend-following returns tend to be uncorrelated with other investments over the long run, their correlations with equity and other growth-oriented risks can be volatile over shorter time horizons and may not be as low as expected during crisis conditions. “The dumbest reason in the world to buy a stock is because it’s going up.” – Warren Buffett Even Warren Buffett would be hard-pressed today to find any mean- ingful assets selling at an attractive discount.
  6. 6. 6 Show Me the Money Far be it from us to argue with Warren Buffett—but we will. To support academic claims of trend-fol- lowing’s positive excess returns over cash, we compared the cumulative returns of a trend-following index (BarclayHedge BTOP50) versus stocks (S&P 500) and bonds (Barclays Aggregate) since 1987.6 BTOP50’s cumulative returns since its inception land between the S&P 500 and Barclays Aggregate, well above cash, net of underlying manager fees (Exhibit 2). 1,590.37% 174.29% 548.01% -250% 0% 250% 500% 750% 1,000% 1,250% 1,500% 1,750% 09 10 11 12 13 14 1508 CumulativeReturns 16070605040302010099989796959493929190898887 Declining periods (S&P 500)3-Month T-Bill Barclays AggregateS&P 500 BarclayHedge BTOP50 854.00% Sources: Barclays, BarclayHedge, Federal Reserve, Standard & Poor’s. 6 The available history of BarclayHedge BTOP50 Index begins on January 1, 1987. Sources: Barclays, BarclayHedge, Credit Suisse Hedge Fund Index, Standard & Poor’s, Societe Generale. 1.00 0.01 -0.05 Credit Suisse Managed Futures 09 10 11 12 13 14 1508 Correlation 160706050403020100999897969594939291 -1.0 -0.5 0.0 0.5 1.0 0.02 SocGen Trend Index -0.07 Barclays AggregateS&P 500 BarclayHedge BTOP50 Exhibit 1 Rolling 36-Month Correlation vs. S&P 500 Index for 25 Years ended June 30, 2016 Exhibit 2 Cumulative Returns since January 1, 1987
  7. 7. 7Knowledge. Experience. Integrity. Compared to the S&P 500, bonds and trend-following strategies show a similar performance pattern over market cycles (Exhibit 3). During declining markets, both bonds and trend-following have provided offsetting returns that can smooth out returns in a broadly diversified portfolio, albeit for different reasons. Income with principal protection lifts bonds, while major moves from stocks and bonds usually provide profits for trend followers. Performance for all asset classes will likely be very different than it was for the last 30 years, which was marked by declining interest rates. Low bond yields today are indicative of bond returns tomorrow. High stock multiples with low dividend yields are also predictive of returns for equities. Since significant cash balances are held in margin accounts for underlying derivative positions of trend followers, today’s low interest rates are also hurting their prospective nominal returns. In contrast to stocks dependent on eco- nomic growth and bonds dependent on stable inflation, the future for trend-following will lean on neither of those. Instead, it will depend on market volatility and uncorrelated movements between stocks, bonds, currencies, and commodities to sustain profitable trends and diversifying benefits. Transaction costs and fees will also be an important consideration, as lower return expectations make it tougher to justify expenses being charged by managers and their service providers. Make Your Own Mojo Given its foundation on the timeless ebbs and flows of fear and greed, momentum has staying power as a positive long-term risk premium. Whether momentum is captured in absolute or relative terms, this strategy focused on identifying and riding trends across stocks, bonds, currencies, and commodities requires much more disciplined risk management than traditional buy-and-hold strategies. The unpredictable nature of market cycle timing does leave this strategy vulnerable to both sudden market reversals and range-bound markets. However, given today’s combination of increasingly return-starved investors and slowing economic growth, markets crashing to earth or spinning out of orbit are palpable risks. Being prepared to embrace either direction is the diversifying edge behind trend-following strategies. Otherwise, like the crew of Apollo 13, investors should fasten their seatbelts for a bumpier ride. 0.00% -61.66% -83.77% -100% -50% 0% 50% 100% 09 10 11 12 13 14 1508 16070605040302010099989796959493929190898887 CumulativeRelativeReturns -43.56% Declining periods (S&P 500)3-Month T-Bill Barclays AggregateS&P 500 BarclayHedge BTOP50 Sources: Barclays, BarclayHedge, Federal Reserve, Standard & Poor’s. Exhibit 3 Cumulative Returns Relative to the S&P 500 Index since January 1, 1987 Given its foundation on the timeless ebbs and flows of fear and greed, momentum has staying power as a positive long- term risk premium.
  8. 8. 8 About the Author James C. McKee is a Senior Vice President and Director of Callan’s Hedge Fund Research group. Jim specializes in hedge fund research addressing related issues of asset allocation, manager structure, manager search, and performance evaluation for Callan’s institutional clients. Jim is a shareholder of the firm. Jim joined Callan in 1989. Prior to his career at Callan, Jim worked with the Pacific Stock Exchange (PSE) from 1982 to 1989. Until 1985, Jim worked on the PSE’s options trading floor. Thereafter, as man- ager of the PSE’s securities research department, he was responsible for developing and monitoring new stock, bond, and option listings. Jim earned an MBA in Finance from Golden Gate University in 1987. His graduate studies focused particularly on publicly traded securities and capital markets. He received his BA in Economics/Environ- mental Studies from Dartmouth College in 1982.
  9. 9. 9Knowledge. Experience. Integrity. Certain information herein has been compiled by Callan and is based on information provided by a variety of sources believed to be reliable for which Callan has not necessarily verified the accuracy or completeness of or updated. This report is for informational pur- poses only and should not be construed as legal or tax advice on any matter. Any investment decision you make on the basis of this report is your sole responsibility. You should consult with legal and tax advisers before applying any of this information to your particular situation. Reference in this report to any product, service or entity should not be construed as a recommendation, approval, affiliation or endorsement of such product, service or entity by Callan. Past performance is no guarantee of future results. This report may consist of statements of opinion, which are made as of the date they are expressed and are not statements of fact. The Callan Institute (the “Institute”) is, and will be, the sole owner and copyright holder of all material prepared or developed by the Institute. No party has the right to reproduce, revise, resell, disseminate externally, disseminate to subsidiaries or parents, or post on internal web sites any part of any material prepared or developed by the Institute, without the Institute’s permission. Institute clients only have the right to utilize such material internally in their business. If you have any questions or comments, please email institute@callan.com. About Callan Callan was founded as an employee-owned investment consulting firm in 1973. Ever since, we have empowered institutional clients with creative, customized investment solutions that are uniquely backed by proprietary research, exclusive data, ongoing education and decision support. Today, Callan advises on more than $2 trillion in total assets, which makes us among the largest independently owned invest- ment consulting firms in the U.S. We use a client-focused consulting model to serve public and private pension plan sponsors, endowments, foundations, operating funds, smaller investment consulting firms, investment managers, and financial intermediaries. For more information, please visit www.callan.com. About the Callan Institute The Callan Institute, established in 1980, is a source of continuing education for those in the institutional in- vestment community. The Institute conducts conferences and workshops and provides published research, surveys, and newsletters. The Institute strives to present the most timely and relevant research and educa- tion available so our clients and our associates stay abreast of important trends in the investments industry. © 2016 Callan Associates Inc.
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