March 26, 2015

In 2009, Clifford Asness, Tobias Moskowitz and Lasse Pedersen published a paper titled “Value and Momentum Everywhere”. The rationale behind their analysis was simple – value bias investing generates returns that are lowly, or even negatively correlated with a “momentum” style of investing. Value investors invest in stocks that are fundamentally cheap, whereas momentum investors allocate capital on the basis that what has gone up should continue to go up. Diversifying your portfolio across stocks exhibiting a value profile and those that have had strong momentum behind them will likely generate better risk-adjusted returns than investing in either of these styles in isolation. The sweet spot is in finding stocks that combine both styles. This is perhaps why Apple has been a hedge fund darling for so long; it has been showing lower than average cash flow, earnings and sales multiples when compared to competitors and the broader market while enjoying a powerful momentum that has propelled its share price up by a factor of 25 in 10 years.

Intuitively, this approach makes sense – if a stock is cheap and starts to go up, perhaps it is on its way to correct its cheapness. If this is the case, it should outperform its peers and the broader market once this is corrected for. In addition, financial practitioners know that sources of diversification in equities are rare, and anything that lowers the risk of one’s portfolio while keeping its expected return constant is worth having. In combining value and momentum, a portfolio manager can have his or her cake and eat it too, in theory.

Sadly, this beautiful concept finds substantial limitations in everyday investing. We find that value as a style works well, but only if the investment window reaches several years – at least according to professor Robert Schiller at Yale.  He argues that the minimum window of value investments should be 8 years, with better results for those willing to invest over a period twice as long. Besides, value only offers a long-term premium when applied to very small stocks as pointed out by Israel and Moskowitz at AQR Capital, a large US-based asset management firm run by Asness himself.

Along with Kent Daniel, a scholar at the Kellogg School of Management, we find that the growth style of investing combines much better with momentum than with value to generate excess returns. Consider this, a portfolio of the stocks that rank highest according to momentum and value metrics has generated 100 bps of excess performance over the S&P500 in the last 10 years. This, however, comes with a larger maximum drawdown of -55.5% vs. 52.6% for the S&P500. By contrast, a growth and momentum portfolio of 10 stocks has beaten the S&P500 by an average of approximately 18 percentage points per annum over the same period. This also comes with a lower maximum drawdown (-41.8%).

Beyond the real-world shortcomings of combined value and momentum investing, at MONOGRAM we believe that the prism through which Asness and his colleagues look at these issues is indicative of the faulty way the financial community addresses these issues. We believe that drawdown, and not volatility, is the true measure of risk. This is because our investors care much more about the risk of losing a large chunk of their capital (“drawdown risk”) than the day-to-day capital markets turnings (“volatility”). With no offense to Mr. Asness, since combining value and momentum reduces the volatility of a portfolio without reducing its drawdown risk, it is of little practical interest to us. Momentum does that alone, as an enormous amount of literature has repeatedly shown, and we see little upside in polluting its benefits by combining it with a value filter.