(By David Brickell) Throughout the great rise of the fund management industry, funds have been categorised by agencies such as Morningstar as either having a ‘Growth' or ‘Value' bias or some blend in between. Yet in just over 20 years, the pursuit of ‘Momentum' – buying shares on rising prices on the basis that they will often go on to rise higher – has become a popular and increasingly well-researched approach. Momentum, it's been argued, does a far better job than growth. So much so, that the argument in support of buying growth stocks as an equity style at all has been called into question.
The essence of this argument was proposed in a 2009 document by US investment group AQR Capital Management. In it, AQR banged the drum about the notable absence of momentum on the investment landscape and introduced a Momentum Index to not only prove its point that growth investing could be bettered but also to provide asset managers with a momentum benchmark. While AQR was probably keen to sell a new fund on the back of this index launch, to give them their dues, some of those behind the launch had been influential contributors to the thinking behind momentum right from the start.
Cliff Asness, the ex-Goldman Sachs analyst and founder of AQR, was one of a number of researchers behind a 2009 paper called "Value and Momentum Everywhere". Among his co-writers was Tobias Moskowitz, an academic that has written at length on momentum (and who also wrote the AQR research). Their paper concluded that value and momentum worked so effectively together that investors should seek to blend the two strategies:
"The negative correlation between value and momentum strategies and their high expected returns makes a simple equal-weighted combination of the two a powerful strategy that produces a significantly higher Sharpe ratio than either stand alone and makes the combination portfolio far more stable across markets and time periods than either value or momentum alone."
In the AQR research that followed the academic work, the argument made was that whichever way you looked at it, chopping growth stocks out of a portfolio and introducing momentum produced superior returns and improved Sharpe ratios.
What is a Sharpe ratio?
Sharpe ratios are a byword for risk-adjusted returns. Developed by US finance professor William Forsyth Sharpe, you calculate the ratio by taking the average previous return and subtracting the risk-free return and then dividing by the volatility (standard deviation) of returns over a given period. The higher the Sharpe ratio, the greater the return per unit of volatility or the better the risk-adjusted return.
What AQR found was that as you reduced the exposure to growth stocks in a portfolio, and added momentum stocks, the overall return improved, as did the Sharpe ratio. In other words, an investor would get a better return with less risk. As the chart shows, a portfolio of Russell 1000 growth stocks between January 1980 and April 2009 produced a return of 10.5% and a Sharpe ratio of 0.22. By contrast, replacing those growth stocks with momentum stocks delivered a return of 13.8% and a Sharpe ratio of 0.39.
The researchers did the same test using an initial portfolio of value stocks, replacing half of them with momentum stocks. What they found was that while the value/momentum portfolio didn't perform quite as well as momentum-only over the period (the return was 12.8%), volatility was lower and the Sharpe ratios were marginally higher with the combined portfolio – backing up the case made in the Value and Momentum Everywhere paper.
Think twice about growth
In the ongoing debate about the causes and credibility of momentum investing, Asness, Moskowitz and the other researchers developed a robust argument for taking the technical approach. At least one observation since the 2009 research is that there has since been a rapid increase in the number of momentum ETFs available to investors. That said, traditional growth investors could well claim that the pursuit of capital gains from companies that are expanding and growing their profits has a much longer proven track record.
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