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Factor momentum

20 nov 2020

Dear investors,

October was dominated by negative Covid-19 news, with infection rates surging in Europe as well as the United States. The prospect of another batch of widespread restrictions, together with the uncertainty around the 2020 US elections, did not excite investors. Overall, the shift in sentiment from ecstatic during the summer months to more neutral levels in October caused developed markets to end the month about 2.5% lower. In November fears around Covid-19 quickly subsided however, as the announcement of Pfizer and Moderna’s vaccine test results sounded very promising. Investors also reacted quite well to the election of Joe Biden as president of the United States – much better than Donald Trump at least. While Biden may have won the race, the republican majority in the senate will likely not allow him to push as much regulations on certain sectors or reverse certain tax breaks that were undertaken by the previous administration.

Evidently, cyclical sectors and those factors that suffered the most during the lockdown (i.e.  value) rallied extensively after the test result announcements. Yet, there’s still a long way to go before their returns come anywhere close to those of the stay-at-home stocks. And while value may be due for a rebound, it is up against a strong force - namely factor momentum.

While it is well-known that stocks that did well over a certain trailing period (i.e. 12 months) continue to do well in the subsequent month, this very same momentum effect is found in investment factors. To show how pervasive this effect is, we will do a small experiment with the following factors that can be found on the Kenneth French data library: SMB (size premium), RMW (profitability premium), CMA (investment premium), HML (value premium) and MOM (momentum premium). The analysis runs from 1964 to 2020.

 

Equally Weighted

Positive Factor Momentum

Top 3 Momentum

Return

3.93

5.65

6.05

Risk

4.48

7.38

6.96

Return/risk

0.88

0.77

0.87

End value $

$8.61

$20.45

$26.06

 

In the base case we invest 20% in each these five Long-Short portfolios. Over the last 56 years this self-financing portfolio returned 3.93% on average with a volatility of 4.48% - not a bad deal! Yet, if we were only to invest in factors that have a positive trailing 12-month momentum the return would have been enhanced to 5.65%. Moreover, if we were to only select those 3 (out of 5) factors with the best trailing momentum the return further increases to 6.05%. While you can triple your returns over the 56-year holding period, this does come at the cost of increased risk, as reflected by the higher standard deviations. This ‘risk’ can be toned down by incorporating the trailing one-month return in your analysis, but this will of course come at the cost of increased turnover…

While Vector Navigator lost 2.3%, a result in line with the MSCI World index, Flexible handled the volatility a bit better and lost only 0.9% during the month.

Best regards,

Werner, Thierry & Nils