One of the principal lessons of portfolio theory is to combine assets that do not move perfectly together or even move in opposite directions so that the combination pays positive returns on average while reducing risk or uncertainty as much as possible. The risks in this portfolio tend to partially cancel each other out because the value of one stock is likely to be up when the other is down. Instead of picking a single security, an investor can reap the benefits of diversification by choosing the right combination of assets.
What would happen, then, if investors combined investment strategies and different asset classes rather than just individual stocks? Though many studies have analyzed the merits of following one strategy or another, a recent research paper titled, "Value and Momentum Everywhere," Clifford S. Asness, Tobias J. Moskowitz, and Lasse H. Pedersen. Journal of Finance, forthcoming, finds that an investor can gain tremendous diversification benefits by blending two proven investment strategies - value and momentum - and by combining these styles across diverse markets and asset classes - government bonds, currencies, and commodities, as well as equities.
Value investing entails buying stocks that are trading at low prices relative to their fundamental or intrinsic values, and selling those that are expensive. Momentum investing, on the other hand, involves buying stocks whose prices have been rising and selling those that have been falling. A stock that is becoming expensive would be attractive to a momentum investor but not to a value investor. Similarly, a momentum investor would sell a stock with a falling price - a stock to be scooped up by a value investor.
That these two styles seem to be at odds with each other is precisely why they work so well together, the authors find. Momentum investing works at a shorter horizon of less than a year, while value investing is a long-term phenomenon. For instance, during the technology boom that began in the mid-1990s, momentum investors generated far better returns than value investors, who avoided hot technology stocks that were rapidly increasing in price. But when technology stocks crashed five years later, value investors produced bigger returns because they were holding stocks elsewhere.
A combined strategy would have allowed investors to capitalize on such extreme market events in both directions, without the probability of a big loss. "What you have effectively created is a strategy that in the long run has positive returns but in the short run has muted losses," says Moskowitz of combining momentum and value investing.
Mixing Value and Momentum Everywhere
The strategy is not about picking and choosing a particular stock that has the potential to become valuable and, at the same time, is showing signs of momentum. "You literally apply this strategy to thousands of securities all at once," says Moskowitz.
To use this investment style, fund managers would rank all stocks based on value and momentum measures. The price-earnings ratio and price-to-book ratio, for example, are two important measures of value. To find momentum, a common yardstick is the most recent 12-month cumulative stock return. Managers would then buy the top one-third of stocks-that is, those that have high book-to-value ratios and performed well in the past year - and sell those in the bottom one-third based on the same measures. Portfolios would be adjusted every year to make sure that managers are holding the top group and have sold the bottom group.
In Asness, Moskowitz, and Pedersen's paper, this strategy is applied not only to US equities but also to stocks in Japan, the United Kingdom, and continental Europe, and to country equity index futures, currencies, commodity futures, and bonds. The authors analyze how the performance of a blended value and momentum style across markets and assets compares with individual portfolios of value and momentum.
They find that in every market and asset class, a value and momentum combination outperforms either value or momentum by itself in terms of risk and return.
A value investor in US stocks can expect to outperform the overall stock market by 3 to 4 percent a year, while a momentum investor is expected to earn 4 to 5 percent more than the market each year. Both strategies have about the same amount of volatility, which measures the risk that the actual return investors get is different than what they expected. Combining value and momentum yields a return that is 5 percent higher per year than the market. Though this is only slightly higher than the returns from either strategy, the big difference is that volatility falls sharply by approximately 50 percent.
The benefits are even larger when this blended strategy is applied worldwide and to various asset classes - an investor's expected return would be twice the return on investing in the overall US stock market given the same amount of volatility.
Improving a portfolio's risk and return trade-off is important because a good investment should generate higher returns without adding more risk. The strong negative correlation between value and momentum within and across assets and markets gives investors long-term positive returns while mitigating risk, compared with following either a value or momentum strategy alone.
A Common Source
The most surprising result of the study, Moskowitz says, is not just that the combined strategy works in every market and asset class, but that it works at the same time across the board. Even though these asset returns are typically not correlated, the returns on value and momentum investing in these assets are.
For instance, US stock returns are not closely correlated with those of other types of assets, but the authors find that when value investing performs well in US stocks, it also tends to do well in currencies, government bonds, and commodities. The same holds for momentum. Value and momentum also are consistently negatively correlated across asset classes and markets. When a momentum investor is doing well in US stocks, a value investor will likely be doing poorly in foreign stocks and other securities.
This finding highlights a striking pattern that would have gone unnoticed if researchers simply analyzed each strategy in isolation or looked only within a specific asset class or market. Given the different types of securities in each market, the geographic dispersion of these markets, their differences in institutional and market structure, and the different types of investors participating in these markets, the consistent correlation pattern makes a compelling case for the presence of common global risk factors related to value and momentum. "It tells you that there is something simultaneously going on in all of these markets worldwide that is related to value and momentum strategies," says Moskowitz.
Asness, Moskowitz, and Pedersen look forward to future research studies that uncover what drives the correlation between value and momentum across such diverse assets and markets. Their own investigation into the source of the correlations leads them to find some evidence that global liquidity risk-particularly funding liquidity-plays a role. Funding liquidity is the ease with which traders can borrow money to finance transactions. When borrowing is tight, momentum investors tend to do badly while value investors tend to do well. This factor may partially explain the negative link between the two strategies.
Moreover, the importance of liquidity risk seems to be a more recent phenomenon, the study finds, particularly after the Russian debt crisis of 1998 that affected former hedge fund Long Term Capital Management. This event may have roused concerns about the risk that funding will suddenly become unavailable, making investors more sensitive to such shocks at a time when value and momentum strategies are becoming more popular among leveraged traders. It also is possible that the number of hedge funds and other traders has increased so much since then that funding liquidity has become an increasingly important factor in their investment strategies.
Nevertheless, liquidity risk is only one part of the explanation for the study's intriguing results. "It is still an open question, a puzzle," says Moskowitz.
“Value and Momentum Everywhere,” Clifford S. Asness, Tobias J Moskowitz, and Lasse H. Pedersen. Journal of Finance, forthcoming.