Momentum and value investment strategies target superior returns on a standalone basis, but can be combined to bring diversification and risk management to a portfolio. These and other factors are associated with an above-average risk premium.
Momentum investing follows trends in the market by taking a long position in high-returning assets while short-selling those which are on a downward trend (in the case of long-short funds). It is based on the assumption that recent return trends will persist into the future, partly because of behavioral biases whereby investors collectively become overconfident in winners while losers fall out of favour.
Momentum investing is relatively short term, given that it tracks recent trends, and so this approach can incur frequent rebalancing costs, sometimes as often as monthly.
The value approach targets assets which are undervalued relative to their intrinsic value, since those assets are likely to revert to their fair value over the long term. Long-short value investing involves buying undervalued stocks and selling assets which are expensive.
Credit Suisse’s Global Investment Returns Yearbook for 2016 analysed how these and a number of other factors influenced long-run returns, and included a particular focus on their responses to changing interest rates.
The report notes that while falls in interest rates boosted excess returns for value strategies in both US and UK markets, lower rates lifted the momentum premium in the UK but not the US. This was pinned on the inherent volatility or risk of the momentum premium given the strategy’s sensitivity to reversals in financial markets.
Value and momentum strategies can be implemented through long-only investing or through long-short positions. They are common factor investing techniques and their proponents say that individually, they produce excess returns over the long term. For example, the 2011 edition of the Credit Suisse report said that in the UK, momentum stocks yielded a 1% momentum premium each month.
Combining momentum and value strategies
Long-short momentum and value strategies are often combined since they tend to perform at different phases of the market cycle – a characteristic which helps to smooth long-term performance and control volatility risk.
The diversification benefits are less applicable to long-only portfolios, since factors tend to be correlated to some degree given their underlying exposure to equity markets. However, the performance of long-short momentum and value strategies is not dependent on market conditions since they target absolute returns. Hence, correlation is low and diversification benefits high.
In essence, momentum strategies perform when prices continue in the same direction while the value approach delivers when prices move in the opposite direction. For that reason, the approach to combine the two strategies helps to manage risk.
While many investors might target a 50:50 split between value and momentum strategies, for example, some might opt to increase the weighting to one when that strategy is outperforming the other. This of course dilutes the diversification and risk-control benefits of combining these strategies, but can generate higher returns.
Similarly, long-only investors can combine value and momentum into a single strategy, where stock selection is based on analysing stocks by their underlying value and momentum characteristics. This can be implemented by giving stocks an overall value-momentum score or by buying stocks when they are displaying both characteristics.
This approach allows investors to identify those stocks which are experiencing an upswing, or recovery, after a period of underperformance, or simply identifying assets which have upward momentum.
Value and momentum strategies aim for excess returns, making them alpha strategies when implemented in a long-only portfolio.
Other factor models, however, including equal risk contribution indices, strive mainly to control volatility and protect against risks.