“The premier anomaly is momentum.” – Eugene Fama and Kenneth French

There is momentum in theory and there is momentum in practice. Momentum in theory is the premier market anomaly. Momentum in practice is a bit more complicated.

What is the look-back period (3 months, 6 months, 12 months, etc.)?

What is the rebalance frequency (monthly, quarterly, etc.)?

What is the universe (S&P 500, Russell 1000, Russell 2000, Russell 3000, etc.)?

What is the style (long-only or long-short)?

What are the number of holdings (what % of stocks (top 10%, 20%, etc.) are you using to define “momentum”)?

What are the weighting rules (market cap, equal, volatility, etc.)?

What is the expense ratio?

What are the trading costs?

What are the tax implications?

Few know to ask such questions. Fewer still would know what to do with the answers if they had them.

To illustrate, let’s take a look at one of the more popular momentum products in the marketplace: the AQR Large Cap Momentum Style Fund (AMOMX). Launched in July 2009 by AQR, the fund offers “systematic exposure to stocks with positive momentum.”

What does that mean in plain English?

AQR ranks the largest 1,000 U.S. stocks by their prior 12-month total return and selects the top 33% of stocks with the highest rankings. Next, they weight the selected stocks by market cap with a “tilt” to “higher momentum stocks.” Once every quarter, they repeat this procedure and rebalance the portfolio.

That leaves us with some of idea of what they are doing, but how can we be sure that what they are doing is the best way of doing it?

We can’t.

The academic research on momentum provides considerable leeway in terms of how to actually execute on the idea that “buying past winners and selling past losers” is an alpha-generating strategy.

In this particular fund, AQR’s choice of style (long-only), universe (largest 1,000 stocks), look-back period (12 months), rebalancing (quarterly), and weighting (market cap with a “tilt”) is one variation among many. It may be a better or worse variation than the others but one can only know that in hindsight.

But AQR manages $175 billion in assets and over $900 million in this fund alone. Isn’t that proof that they know the best variation?

Unfortunately, it doesn’t work that way. There is only what has “worked best” in the past but that is far from what will work best in the future. AQR has some of the smartest minds in the business. They have been running momentum portfolios longer than just about anyone else (since 1998). I have learned a great deal from their research. They are very good at what they do. But all of that doesn’t change this one simple fact: they cannot predict the future. They cannot tell you what variation will work best.

Even if they could predict the future and knew what momentum variation will “work best,” there are other business considerations that might take priority.

When you’re as large as AQR, the objective is not as simple as “launch the best strategy,” but instead to launch the “best strategy that is scalable.” The two are not always one and the same as Patrick O’Shaughnessy illustrated in a great writing on value strategies.

How can we tell that AQR is concerned with scale (assets) as well as returns (alpha)?

For starters, at the end of last year, they had 496 stocks in their AMOMX portfolio. Doing simple math, that is almost 50% of their benchmark universe. How does one reconcile that with their stated objective of selecting the “top 33%” of stocks with the “highest rankings?”

Well, AQR also states that “the fund does not follow this approach mechanistically” but instead “maintains flexibility to trade opportunistically in order to strike a balance between maintaining the desired exposure to positive momentum, while attempting to minimize transaction costs.”

In striking that balance, they have increased the number of names in the portfolio to the point where alpha-generation from momentum is likely to take a hit (see Jack Vogel of Alpha Architect’s excellent post on this and chart below). And by using “market cap” instead of equal weighting, they are further deviating from a pure momentum strategy.

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Source: How Portfolio Construction Affects Momentum Funds via Alpha Architect

What you’re left with is a portfolio that, while certainly different than the benchmark Russell 1000 Index, is not nearly as different as one might expect from a fund that has “momentum” in its name.

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The return stream/path supports this, as the AMOMX Fund has a .95 correlation with the Russell 1000 since inception. More often than not, they are moving in the same direction, which is not unexpected given the long-only style and overlap of 496 names.

Since the inception of the fund (July 2009), the Russell 1000 ETF (IWB) is up 205% versus a 182% gain for AMOMX. Needless to say, it is hard to beat the index (after expenses and transaction costs) over long time periods when you have a significant overlap with the index.

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That’s not to say that:

1. AMOMX has not done better than the average fund. It has beaten 70% of funds in the “Large Growth” category over the past five years.
2. AMOMX can’t beat the index over short periods of time. It certainly can and there have been years in the past where it has.
3. AMOMX can’t beat the index over longer periods of time. It is certainly possible. Perhaps AQR’s version of momentum in this fund has simply been out of favor since inception and will do much better in the next eight years, bringing up the average. This could very well be the case but no one knows whether it will be or not, including the smartest minds at AQR.

But the real question is not whether it is possible for AQR to beat the index over the long run, but whether it is probable. The research says that by executing a momentum strategy it is probable, but as we know the research world (more concentration and no fees/taxes/commissions/slippage) is not the same as the real world.

What we are left with, then, are a few important questions. Do the odds favor the strategy being different enough (providing enough of a diversification benefit) or strong enough (providing enough excess return) to justify:

a) The higher volatility that comes with it (13.9% volatility vs. 12.6% for IWB).

b) The higher expense ratio of (0.4% vs. 0.15% for IWB), higher transaction costs above this (unknown but certainly higher than IWB), and higher taxes on distributions (more than IWB)?

c) The additional time/energy you will need to understand what you own and hold onto it during the inevitable periods of underperformance.

There are no easy answers to these questions. There is no way to mathematically prove “the odds” of a favorable performance outcome for investors. Even if you knew the future returns for the strategy, you couldn’t predict if an investor would stick with those returns through the ups and downs (the behavior gap was roughly 1.5% over the past five years).

But in terms of being different, we can quantify that much. We can say that a more concentrated, purer form of momentum would be more different and closer to the academic research than the current approach in AMOMX. That’s not to say that the more concentrated momentum version (higher active share) would not come without additional risk (higher volatility or drawdown). It probably would. And that’s not to say that beating the index without significant overlap (i.e. higher active share) would necessarily lead to higher returns. There’s certainly no guarantee of that.

But it is to say that you have more of a chance – to look really bad – and to look really good. Funds with a more concentrated momentum profile, while not as scalable, will look different. This poses additional risks for the asset manager (not as scalable, career risk with greater deviation from the benchmark) and the investor (you have to be ok with higher volatility and looking different than the benchmark on the downside at times) which is why so few managers will offer such an approach.

At the end of the day, momentum is just a term, a description of a particular type of strategy. Just because something has the name “momentum” in it doesn’t mean they are defining it the same way you would. Take the time to understand what that name really means, to know exactly what you own. Only then can you make an educated decision on whether or not it deserves a place in your portfolio.