Today we introduce what will end up being a three part series breaking down three common arguments against trend following. Today's topic- the momentum factor is inherently more "streaky" than other areas of the market like growth or value that your clients know and love.
Note- due to the length of commentary for each studied "pitfall", our team will break down commentary for each individual topic on Wednesday's report over the next two weeks. Next week, we will discuss the frequently made argument that momentum inefficiently chases winners. At the end, we will include a full length version with all items together. We hope you enjoy and find these articles useful in contextualizing trend following for current or prospective clients.
Like any investment process, trend following is not without its share of ups and downs. Over time, buying winners and cutting losers can foster a strong point‑to‑point return stream, but the inter‑period experience of momentum investing can be difficult to stomach as natural rotation occurs and trends change. Time and time again, shifts in leadership create uncomfortable situations that often run counter to our natural “gut” instincts, causing even the most loyal trend follower to consider deviating from the rules. These untimely breakdowns in systematic rule‑following allow emotion to creep in at precisely the wrong moment, potentially erasing years’ worth of discipline- either psychologically, monetarily, or quite often, both.
With that in mind, we have taken the opportunity to break down several of the major roadblocks and common arguments that inevitably arise for trend followers. Our hope is that by better understanding the typical pitfalls of momentum investing, we can more appropriately contextualize returns over time.
Major arguments commonly raised against the momentum factor typically include:
- Trend following is “streaky” and, as a result, does not belong in the average portfolio.
- Trend following often “chases winners” inefficiently, leading to frequent whipsaws.
- Frequent rotation driven by changing market leadership creates material tax inefficiencies.
Momentum’s Streaky Nature: Fair or Falsehood?
While it isn’t entirely false that momentum itself can be streaky, the misnomer in play is the idea that momentum is inherently erratic in comparison to other factors included in today’s average portfolio. To test this, we created a performance quilt of eight different common factors, displaying their yearly returns since 2000 below. They include: Momentum (PDP), Core (SPY), Equal Weight Core (RSP), High Quality (SPHQ), Growth (RPG), Value (RPV), Low Volatility (SPLV) and High Dividend (PEY).
From there, we used the return data to answer the question: Did any specific factor find themselves spending more than a year in a row in the top/bottom quartile (2) of overall performance? If the nature of momentum returns is considered to be erratic, it should potentially lead to more time spent at our performance extremes than other factors.
Across the 26-year sample period, our momentum proxy recorded five episodes in which it ranked within the top or bottom two for at least two consecutive years (19.23% of the time). Comparatively, other factors spend an average of 14.29% fulfilling the same criteria- roughly 3.7 episodes per factor. While this metric does point to a slightly higher “streak factor” for momentum, it’s not as extreme as many assume. The widely accepted value factor, for instance, exhibits eight such streaks in our dataset.
If the length of time of performance streaks isn’t a clear and obvious roadblock to trend following, many momentum naysayers may shift their focus to the apparent magnitude of out/underperformance on any given year. To evaluate this claim, we calculated performance for a narrower set of factors (Low Vol., Value, Growth, and Momentum) during our previously defined streak events, measured relative to our core benchmark. The intuition is simple: the wider a factor’s average range of out‑ or underperformance during streaks, the more likely its return profile deviates from what many would consider a “normal” investment experience. While momentum’s range of average out/underperformance during streaks is the widest in our dataset, it remains broadly comparable to other widely mainstay factors like value (20.09) & growth (17.31). All this to say, the momentum experience certainly experiences its share of streaks, but not at an abnormal frequency or magnitude than other factors.
Disclosures:
Management and other expenses can have a material impact on performance when compounded over time. Past performance, hypothetical or actual, does not guarantee future results. In all securities trading there is a potential for loss as well as profit. It should not be assumed that recommendations made in the future will be profitable or will equal the performance as shown.
Click here for more information from Invesco on the Invesco DWA Momentum ETF (PDP): https://www.invesco.com/us/financial-products/etfs/product-detail?audienceType=Investor&ticker=PDP
Dorsey, Wright & Associates, LLC is owned by Nasdaq, Inc. and we have affiliates who also provide financial services, research, information, and act as Brokers/Dealers to a wide variety of clients. Our affiliates use the information we create to create indexes, which are then used to create Exchange Traded Funds. These things create a potential conflict of interest in that we may have an incentive to promote or use the products and services of our affiliates and business partners. A number of Dorsey Wright representatives are registered with and hold securities licenses with the affiliate broker-dealers. In this capacity, they assist with the marketing and distribution of Exchange Traded Products.
