When pace is slow and steady, volatility can win the race.
By Mark Hulbert
January 24, 2017
Momentum strategies can hold their own, even in a volatile year like 2016. That’s good news, because last year was easily one of the most challenging for momentum strategies. Just recall how many reversals there were during 2016, which whipsawed many momentum traders into doing just the opposite of what they should have done.
For example, the first six weeks of 2016 were one of the worst calendar-year starts for the stock market in U.S. history. Yet, far from continuing its downtrend, the stock market reversed course and shot upwards. The same was true of U.S. stocks in the wake of the U.K.’s Brexit vote and before and after the U.S. election.
The best-performing momentum strategy over the long term, among the couple of hundred strategies I have tracked over the last three decades, is recommended by NoLoad Fund*X, an advisory service edited by Janet Brown. The key to making momentum work, my analysis of this service’s returns suggests, is measuring momentum over just the right length of time.
When momentum is measured over too short a period, followers get whipsawed too many times. And when it’s measured over too long a period, it takes too long to get on board with the market’s new trends.
This sweet spot appears to be the one that NoLoad Fund X has been employing for several decades: Momentum is measured as an average of performance over the trailing one-, three-, six- and 12-month periods.
Needless to say, this strategy doesn’t beat the market every year — and 2016 was no exception. But it has beaten the market over the longer term. Since March 2000, for example, which is when my tracking of Brown’s “Monthly Grader Portfolio” commenced, I calculate that it has beaten the S&P 500 SPX, -0.27% by a margin of 5.6% to 5.1%, annualized. (Both these returns adjusted for dividends.)
Furthermore, this portfolio sidestepped the losses that some momentum strategies suffered last year. It gained 7.8% in 2016, which, while lagging the S&P 500’s 12.0% total return, is still far ahead of the 0.4% loss incurred by what ETFdb.com says is the largest ETF that pursues a momentum strategy — the First Trust Dorsey Wright Focus 5 ETF FV, -0.42% .
To be sure, Brown’s approach has had a more difficult time since 2000 than it did in the 1980s and 1990s. My performance tracking showed that her advice in those decades beat a buy-and-hold by an annualized average of three percentage points, in contrast to the portfolio’s 0.5 percentage point margin since 2000. This result is consistent with that of many momentum traders on Wall Street, who in recent years have declared momentum to be “dead.”
But that is premature, according to research conducted by Ken Daniel, a finance professor at Columbia University, and Toby Moskowitz, a finance professor at Yale University. In a study published in November’s issue of the Journal of Financial Economics, they reported that what’s different about the last two decades is the market’s extraordinary volatility, which is and always has been anathema to momentum strategies. Upon ignoring the most volatile months, they found that momentum has been just as successful in recent years as it was in the past.
Momentum strategies would therefore be genuinely “dead” only if the markets have permanently become more volatile. And, though we may feel as though the future is particularly uncertain right now, uncertainty is and always has been inherent to the markets. There’s no compelling reason to believe that the future will be characterized by more or less permanently high volatility, Professors Daniel and Moskowitz told me in interviews.
Furthermore, it appears possible to hedge your bets again the inevitable periodic bursts of higher volatility. The researchers found that momentum strategies do their best when the market’s volatility over the trailing six months is significantly below average. The suggestion is that you should reduce your investment in momentum strategies whenever volatility spikes, and then increase it again when relative calm returns.
Professor Daniel added that now appears to be a time of sufficient calm to justify making a bet on momentum. The CBOE Volatility Index VIX, -1.10% is trading around 12, after topping 22 last November.
Article Link To MarketWatch: