When it comes to betting on hot performance, focusing on the winning names may not be the best approach
The idea of chasing performance may go against a lot of investing advice, but there is a grain of wisdom to it. Based on data from renowned finance professors Kenneth French and Eugene Fama (who is also a Nobel Prize laureate), a portfolio that held the 10% of stocks with the best trailing 12-month returns since 1927 would have beaten the broad stock market by 6.7% annualized percentage points.
That’s more commonly known as the momentum effect, which investors have used to catch waves of performance that have swelled for companies in a broad range of sectors. But according to new research released by the National Bureau of Economic Research in the US, those who do this may be a little off the mark — and may be better off capturing momentum in a slightly different way.
“The researchers came to this conclusion upon discovering that the stocks held in the high-momentum portfolio at any given time tend to share the same fundamental characteristics—or ‘factors,’ in Wall Street parlance,” reported the Wall Street Journal.
Prior to the research, which was titled Factor Momentum and the Momentum Factor, analysts had assumed that the momentum portfolio’s stocks had nothing in common except for the fact that they had beaten most other stocks over the trailing year. That meant those who wanted to harness the momentum effect had to continually sort through data on thousands of stocks.
With further investigation, however, the proponents of the study — Sina Ehsani, professor of finance at Northern Illinois University, and Juhani Linnainmaa, professor of finance and business economics at the University of Southern California — found that the momentum effect actually manifests at the level of factors rather than individual stocks. That meant investors could get the same performance, with reduced risk, by simply betting on the best-performing factors of the trailing year.
To arrive at that conclusion, Ehsani and Linnainmaa focused on over a dozen pairs of factors, pairing each one off based on their opposite positions on a particular dimension. Aside from market cap (small-cap vs. large-cap), they looked at factors paired on dimensions like quality, liquidity, and volatility.
The findings imply that investors seeking to implement a momentum-based strategy could simply do so using factor-based ETFs. They could look for ETFs that focus on market cap, quality, liquidity, and volatility — factors for which ETFs are more readily available. Once they have found the appropriate ETFs and compiled them into a list, investors can sort their ETF sets every month based on their performance over the past 12 months; they should then take positions in the ones that have beaten the broad market.
“If rebalancing your portfolio each month into the best-performing factor ETFs is too much work, then the message of this new research is simply to continue betting on a factor so long as it has beaten the market over the trailing 12 months,” the Journal said.