Friday, July 22, 2016

What Drives Momentum Performance?

Mar Vista Investment Partners has a really interesting research piece out The Price You Pay which has a great table outlining the benefit of an asymmetric return profile (i.e. having more market exposure during up markets than down markets).

It is a mathematical truism that superior down capture in negative periods provides more capital for compounding in the ensuing positive periods. Using S&P 500® Index monthly total return data for the last thirty years, the chart below demonstrates the expansive value created by preserving capital in the down periods even with subpar returns in the positive periods. Each column shows the ending amount of capital with $100,000 invested in the S&P 500® Index over thirty and ten years with various combinations of monthly up and down capture.

As shown in the table above, even a 10% difference in up / down capture can provide a material impact to returns and the path of returns.

This also happens to explain why momentum works... with a traditional momentum model where you are in either stocks or cash, you will rarely capture 100% of the market's upside (the strategy is not always going to be in stocks when the market is up), but you will by the same math almost always improve the downside capture. The chart below shows the rolling three-year upside and downside capture figures for a basic momentum model and shows momentum often, but not always, provides favorably asymmetry (i.e. upside capture > downside capture). Over the longer-term (50 years), the upside has been 70% vs downside of 56%.

It is the low downside capture during market sell-offs that has driven the strong relative and absolute long-term performance of this momentum strategy. Again... while there have been many periods in which this momentum strategy has underperformed, over the longer-term it has slightly outperformed the S&P 500 since 1966 (10.2% vs. 9.7%) and with a much lower standard deviation (12.7% vs. 18.9%). The chart below shows the tight relationship between three-year excess performance and three-year upside minus downside capture, which points to why momentum strategies have largely underperformed since the 2008-09 correction when markets have generally moved higher.

The momentum investment opportunity becomes even more interesting if you can pair the above return stream with a strategy that may improve up capture during positive market environments, but I'll save that for another day.