## Hot Potato: Momentum As An Investment Strategy

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**Evidence and Explanations**

^{2}In fact, commodity trading advisors (CTAs) have built a profitable business around trading momentum.

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^{4}In the face of uncertainty, individuals estimate the expected future value of an asset by making adjustments to a reference price, that is, an “anchored” value. Investors manifest this tendency by anchoring to the current information (stock price) and being slow to adjust expected future values in light of new information. Thus, prices lag fundamental information and play “catch up” for a few quarters, leading to serial correlation in stock prices. Jegadeesh and Titman concluded that an under-reaction to firm-specific information was the likely cause of momentum. In further support of the anchoring hypothesis, Hong and Stein (1999) found that it takes time for information to be fully reflected in stock prices.

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*It is not a case of choosing those [faces] that, to the best of one’s judgment, are really the prettiest, nor even those that average opinion genuinely thinks the prettiest. We have reached the third degree where we devote our intelligences to anticipating what average opinion expects the average opinion to be.*

**Momentum as an Equity Risk Factor**

^{6}Among the first four equity risk factors, over a period longer than 40 years, momentum registered the highest return and Sharpe ratio (see

**Figure 1**).

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**Figure 2**, the momentum risk factor has earned a

*negative*risk premium for the 13 years ending June 30, 2013. We have also observed that momentum’s strength has eroded over the past decade. Factor-based investing requires strong conviction and a steady hand.

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**Implementation Matters**

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^{10}In the RAFI® Fundamental Index® methodology, contra-trading is accomplished by means of systematic rebalancing to constituent weights that are not related to prices. Rebalancing, in this approach, does not merely correct for style drift; it is integral to the strategy. We favor annual rebalancing because it minimizes turnover and, therefore, transaction costs. Value investing is a long-term proposition.

^{11}But, obviously, more frequent rebalancing entails higher transaction costs. In addition, rebalancing a non-price-weighted portfolio has a strong positive value factor loading and a negative loading to momentum. These opposing characteristics are hardly surprising; momentum and value strategies are themselves opposites—procyclical vs. contrarian, short-term vs. long-term, and based upon trending vs. reverting to the mean. Recognizing these oppositions, I submit that complementing a long-term fundamentals-weighted strategy with a judicious commitment to a short-term momentum strategy might, in aggregate, produce attractive risk-adjusted returns. Indeed, Morningstar found a blended portfolio of value and momentum outperformed a blended portfolio of value and growth by nearly 1% annually.

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**And Yet…**

**Endnotes**

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