Is Momentum a Dead Stock-Picking Factor?

Is Momentum a Dead Stock-Picking Factor?

Does momentum really work? Can you outperform benchmarks by simply holding top-performing securities? I have my doubts, but I've decided to be open-minded and revisit this idea. A decade or two ago, we used momentum extensively to select equity asset classes and avoid the poor performers. I lost faith in momentum somewhere in the 2009 to 2010 time frame after the premium suffered a historically large drawdown in 2009. We turn off momentum at the beginning of new bull markets, so we didn't suffer from this drawdown, but hedge fund assets had grown exponentially to over $2 trillion at the time, and momentum mutual funds were being introduced. The strategy appeared to be very crowded. Momentum was a great trading edge for many decades. Now it's just too easy to do and too popular with an enormous amount of assets implementing momentum in various forms. Let's define the momentum effect. The idea is that top performing assets over a 3 to 12 month time frame tend to outperform over a...

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Don’t Bet on the Active Manager Revival

Don’t Bet on the Active Manager Revival

The massive migration of assets from actively managed equity funds to index funds has attracted a lot of attention lately.1-6 The discussion varies, including worries about the future of active managers, concerns about market efficiency, and claims that active managers are about to outperform, and a variety of social impacts caused by this trend. The flow of assets among U.S. equities is massive and may be a sea-change inflection point in the financial markets. The transition toward indexing has accelerated in the U.S. as more and more professional investment advisors have finally acknowledged the failure of active management. New Department of Labor fiduciary rules also make it more difficult for investment advisors to recommend active managers without exposing themselves to potential litigation risk. Figure 1 from a recent Wall Street Journal article, using data from Morningstar, shows the accelerating trend.1 Similar trends are occurring more slowly among bond funds and...

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Avoid Crowded Trades

Periods of high volatility, sharp sell-offs and bear markets create an environment rich in trading and investment opportunities for those that remain level-headed and prepared. As prices recover and the next equity bull market develops, all risk-on trades generally work. Eventually the bull market ages, and finding new trading ideas becomes a bit more challenging. Developing successful trades in this environment requires creativity and hard work, searching for ideas that are good, yet not so well known as to be crowded, and therefore ineffective. This is easier said than done. Most traders tend to pile into similar mid- and late-cycle trades, which are often marginal with respect to an edge, or tend to be based on economic predictions and/or secular themes rather than exploiting another group of investors. When too many traders are in the same trade, it becomes crowded. As you might expect, crowded trades lose their edge, and thus should be avoided. That is a good rule to live by,...

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Seasonality

In this blog I’ll examine the old “sell in May and go away” seasonal pattern associated with risky assets. It’s timely to consider this pattern since the markets are now entering the seasonally weak period. Furthermore, stock market performance has been relatively weak in a number of recent “strong periods,” such as in January 2016, November 2015 through January 2016, and November 2015 through April 2016, which often provides a foreboding tell of additional weakness during the traditional seasonal weak period of May through October. Seasonality as a trading edge is also worth considering because trend following has become very trendy these days, with billions of dollars flowing into this discipline every year via managed futures funds. The problem with these flows is that the effectiveness of trend following diminishes as more assets are devoted to the discipline, since trend following is naturally capacity constrained due to high turnover (>200%) and the liquid demanding nature...

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Stale Pricing

A stale pricing edge occurs when a security or fund can be purchased or sold at a price that is stale with respect to current up-to-the-second information. This trading edge is as fleeting as a twenty dollar bill sitting on a busy sidewalk. For instance, if the price of a U.S. equity closed-end fund is sitting at bid $10, ask $10.10 for most of the day without trading activity, and the S&P 500 trades up 2% during the day, the ask price of $10.10 may be too low, and therefore, stale. Then buying at the bid can provide a risk-free profit (if hedged by an S&P 500 short) of at least 10 cents, since the fund should be trading at $10.20/$10.30. You'll never find stale prices with liquid large cap equities or ETFs. Only rarely do they occur with securities that don't trade very often, such as closed-end funds. The stale price edge is not backtestable with price data since simulated orders would have affected prices at the time. Generally, we'd expect stale price opportunities to...

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Top 10 Thought Leaders for Asset Class Traders

The beginning of the year marks the time when chief investment officers, market strategists and other chief prognosticators publish their top investment themes. Barron's also publishes their much anticipated “round table” issues in mid to late January, which pull together top investors to discuss the state of the markets and where they see investment opportunities. There are hundreds of firms producing research all the time, most of it free. The big Wall Street firms produce enormous amounts of content, but so do practically all buy-side investment management firms these days. If you're not careful, combing through research reports for trading and investment ideas can absorb all of the day. There are also the independent firms such as Ned Davis Research, BCA Research and the Leuthold Group, which are very expensive, but provide lots of interesting and useful information for asset class traders. Common sense suggests that you can't just read the research, implement the trades...

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A note to readers

I've been delayed in posting the next blog entry due to my current heavy work load, which is intensified by recent market conditions. This will happen occasionally. Our clients come first, and this blog will have to take a back seat when my daily workload becomes too intense. My target posting rate is one per month. There is no rush. The primary purpose of the blog is self-mastery, which is ultimately a long-term pursuit. In addition, there are times when a blog post I'm working on just doesn't come together well. As I write about a particular subject, inconsistencies cause me to rethink the premise. That is the purpose of the blog - to explore the nuances of what works in trading asset classes. I’m currently working on a half dozen blog posts in various forms, but with each I've hit stopping points where the logic is not complete. Recently, Alex Golubev and I worked on the concept of divergences. Throughout my career I've taken notice of divergences when trading asset classes. When...

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Trend-Following Market Timing

Cut your losses short, and let your profits run. For centuries, that's probably the number one trader's adage. This is exactly what the trend following (TF) investment discipline does – using simple rules to be long markets in uptrends and short markets in downtrends. The mathematical rules used to identify uptrends and downtrends are predefined and mechanically implemented to eliminate human emotions in deciding when to be in or out of a market. The most common way trend following is implemented is with managed futures funds, which are typically placed in the “alternatives bucket” of an investment portfolio, perhaps making up 5% of the total. A good example of such a fund is the AQR Managed Futures Strategy Fund (Symbol: AQMIX). Managed futures funds apply the trend-following discipline to various equity and fixed income markets, along with currency pairs and commodity futures. In this blog, I'll examine the trend-following approach applied to asset classes that have a positive risk...

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Does Technical Analysis Work?

An essential component of successful trading is having a good sense of timing. The standard industry tool for getting the timing right is technical analysis, so we need to examine its effectiveness. I'll assume the reader is familiar with technical analysis, and as an asset class trader, I'll also assume we control a limited amount of assets such that positions can be bought and liquidated with minimal trading impact costs. For extremely large asset management firms and hedge funds, technical analysis is not an available tool because all-in trading costs are prohibitively expensive with this approach. These firms are forced to use other approaches such as value investing, which is, ironically, a horrible tool for timing price moves. Even large trend following CTAs are forced to use the most liquid futures contracts to minimize trading impact costs. So perhaps being small and using technical analysis is an advantage for us. In a nutshell, technical analysis is the analysis of price...

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Follow the Flows – The Last 20 Years

In the last blog, I discussed the trading edge associated with predicting investment flows. In this blog, I'll provide examples using this trading edge to pick outperforming asset classes. Of course, this is a hypothetical exercise with the full benefit of hindsight, and as is often the case, flows may not be the only cause of the observed performance. 1995 to 1999 This era is widely recognized as the culmination of the 1982 to 1999 secular bull market in U.S. equities. As shown in Figure 1, it was a time when retail investors were obsessed with stocks as illustrated by the meteoric rise in CNBC viewership.1 Index investing was also becoming very popular, but at that time indexing solely meant investing in the S&P 500. Mutual fund managers were the investment stars of the era. Figure 1. CNBC viewership history.1 Figure 2 from Ned Davis Research shows equity mutual fund net flows as a percentage of U.S. market capitalization from 1960 to present.2 These flows can be attributed...

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