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Set value investing against momentum investing, looking at what each tends to earn and how risky each is.

FRM® Part II · Risk Management and Investment Management · Factors · FRM2.IM.2.e

The idea

Value buys cheap assets and is contrarian. Momentum buys recent winners and sells losers, so it follows trends. Winners are usually ranked on the past 12 months excluding the latest month. Historically both have earned positive average premiums, with momentum's often comparable to or larger than value's. Their risks differ. Momentum has high turnover, so trading costs absorb part of its premium. It also suffers sudden crashes, typically when markets rebound sharply after a decline, because the short leg of losers is high beta and snaps back. Value has lower turnover but can underperform for long periods. The two strategies tend to be negatively correlated, so combining them diversifies and raises the Sharpe ratio above either alone. The usual mistake is to compare average returns and ignore costs, crash risk and correlation.

Formulas

Strategy premium net of trading costs

net premium = gross premium − turnover × cost per unit of turnover

gross premium
the strategy's expected return before costs
turnover
the annual turnover, as a multiple of the portfolio
cost per unit of turnover
the trading cost for each unit of turnover

Momentum's high turnover can reverse a gross advantage over value; comparing gross premiums alone is the usual mistake.

A practice question

From the question bank, with the reason each wrong option is wrong.

Which of the following describes a momentum strategy?

  1. Buying assets with the lowest price relative to book value and selling those with the highest price relative to book value.Why not: Describes value investing, which ranks on fundamentals, not past returns.
  2. Buying assets with the strongest returns over the past 3 to 12 months and selling the weakest. - correct
  3. Buying the assets whose recent returns fell the most, expecting an immediate rebound.Why not: Describes a reversal or contrarian strategy, the opposite of following trends.
  4. Holding assets in proportion to their market capitalization.Why not: Describes a market-cap-weighted index, which involves no ranking on past returns.

Momentum ranks assets on past performance and goes long winners and short losers, so it is trend-following. Value ranks on cheapness.

A harder one

Momentum has an expected gross premium of 7% a year with turnover of 400% a year; value has 5% with turnover of 60% a year. Trading costs are 1.0% per unit of turnover. Compared on a net-of-cost basis, which strategy is better and by roughly how much?

  1. Momentum, by 2.0 percentage pointsWhy not: Compares gross premia and ignores trading costs.
  2. Value, by 2.0 percentage pointsWhy not: Applies costs to momentum only (3.0% net) and none to value (5.0%).
  3. Value, by 1.4 percentage points - correct
  4. Momentum, by 2.6 percentage pointsWhy not: Applies costs to value only (4.4%) and none to momentum (7.0%).

Net momentum = 7 - 4.0 x 1.0 = 3.0%. Net value = 5 - 0.6 x 1.0 = 4.4%. Value is better by 1.4 points because momentum's high turnover absorbs much of its premium.

The hardest tier

Which scenario is most likely to produce the worst drawdown for a long-short momentum portfolio?

  1. A sharp market rebound immediately after a prolonged decline. - correct
  2. A steady, low-volatility bull market in which winners continue to outperform.Why not: Trending markets are favourable to momentum, not a drawdown source.
  3. A prolonged bear market that continues falling.Why not: Persistent declines favour the short leg of losers; momentum typically does well in continuing trends.
  4. A gradual rise in interest rates with little change in equity prices.Why not: Without large reversals in stock rankings there is no strong crash driver for momentum.

After a decline, the loser leg is high beta. When markets rebound sharply, losers soar and winners lag, so the short leg loses heavily; these momentum crashes are the main risk.

In the app: 6 practice questions on this outcome, spaced review that brings it back before you forget it.

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