How to Combine Value and Momentum Investing Strategies (Part 1/2)

We are probably most well known for our quantitative value investing strategies. The heart of our strategy is detailed in Wes’ book, Quantitative Value (a reader’s digest version is here). In the development of the Quantitative Value system there is no mention of the concept of “momentum,” which is a well-established empirical anomaly in the academic finance literature and a topic we cover extensively on the blog. And don’t get us wrong, even though we are value-investing fans, we are also HUGE fans of momentum investing.

But that begs a question that we have heard many times over via our readership:

Why don’t you include momentum in your value investing process?

This is a great question and one we will answer publicly for the first time.

Many are familiar with the evidence that value and momentum strategies have beaten the market, historically. And the low historical correlation between value and momentum suggests there is a benefit to combining these portfolios. So why don’t we include momentum in our value investing strategy?

Well, there are a few ways to skin the value and momentum cat:

1. One solution is to combine the exposures as seperate portfolios: part pure value; part pure momentum.
2. Another solution is to “blend” the exposures into a single strategy: an integrated value and momentum system that weighs value and momentum factors and then holds firms with the highest combination.

As evidence-based investors, we decided early on to go with option #1. We aren’t suggesting that option #2 is a bad option, in fact, option #2 is a great solution relative to most security selection approaches peddled in the marketplace. We simply prefer option #1 because it is relatively better than option #2.

Why is option #1 relatively better?

The evidence suggests that we keep highly active exposures to value and momentum in their purest forms (assuming we are doing high-conviction non-watered down versions of the anomalies). Blending the strategy dilutes the benefit of value and momentum portfolios. The summary of the benefits of a pure value and a pure momentum approach can be summarized as follows:

• Easier ex-post assessment
  • E.g., if we mix and match value/momentum it is more difficult to identify the drivers of performance after the fact.
• Stronger portfolio diversification benefits.
  • Pure value and pure momentum strategies have lower correlations than “blended” versions.
• Stronger expected performance.
  • Running pure value and pure momentum in highly active forms generates higher expected performance than blended systems.

The Set-up

First, let’s set up the experiment. We will examine all firms above the NYSE 40th percentile for market-cap (currently around $1.8 billion) to avoid weird empirical effects associated with micro/small cap stocks. We will form the portfolios at a monthly frequency with the following 2 variables:

1. Momentum = Total return over the past twelve months (ignoring the last month)
2. Value = EBIT/(Total Enterprise Value)

We form the simple Value and Momentum portfolios as follows:

1. EBIT VW = Highest decile of firms ranked on Value (EBIT/TEV). Portfolio is value-weighted.
2. MOM VW = Highest decile of firms ranked on Momentum. Portfolio is value-weighted.
3. Universe VW = Value-weight returns to the universe of firms.
4. SP500 = S&P 500 Total return

Results are gross of management fees and transaction costs. All returns are total returns and include the reinvestment of distributions (e.g., dividends).

Here are the returns (7/1/1963-12/31/2013):

The results are hypothetical results and are NOT an indicator of future results and do NOT represent returns that any investor actually attained. Indexes are unmanaged, do not reflect management or trading fees, and one cannot invest directly in an index. Additional information regarding the construction of these results is available upon request.

Takeaways:

1. The universe of stocks is similar to the SP500.
2. The top decile of Value and Momentum outperformed the index over the past 50 years.
3. There is a rather low correlation of 0.5301 between Value and Momentum.
4. Momentum has stronger returns than value, but much higher volatility and drawdowns. On a risk-adjusted basis they are similar.

The Test: Blended Value/Mom vs. Pure Value & Mom

The low correlation between value and momentum suggests there is a benefit to combining these historically high-performing portfolios. There are a few ways in which an investor can attempt to exploit these anomalies:

1. One solution is to combine them as seperate portfolios: part pure value; part pure momentum.
2. Another solution is to “blend” the exposures into a single strategy: an integrated value and momentum system that weighs value and momentum factors and then holds firms with the highest combination.

To help us identify the best approach we set up a small experiment.

We form the following four portfolios:

1. EBIT VW = Highest decile of firms ranked on Value (EBIT/TEV). Portfolio is value-weighted.
2. MOM VW = Highest decile of firms ranked on Momentum. Portfolio is value-weighted.
3. COMBO VW = Rank firms independently on both Value and Momentum.  Add the two rankings together. Select the highest decile of firms ranked on the combined rankings. Portfolio is value-weighted.
4. 50% EBIT/ 50% MOM VW = Each month, invest 50% in the EBIT VW portfolio, and 50% in the MOM VW portfolio. Portfolio is value-weighted.

Results are gross of management fees and transaction costs. All returns are total returns and include the reinvestment of distributions (e.g., dividends).

Here are the returns (7/1/1963-12/31/2013):

The results are hypothetical results and are NOT an indicator of future results and do NOT represent returns that any investor actually attained. Indexes are unmanaged, do not reflect management or trading fees, and one cannot invest directly in an index. Additional information regarding the construction of these results is available upon request.

Takeaways:

• The combination portfolio performs worse than a 50% allocation to Value and a 50% allocation to Momentum. This statement is driven by an analysis of CAGR, Sharpe and Sortino ratios.
• The combined ranked portfolio outperforms the index over the same time period–not a “bad” portfolio construct by any means.
• The 50% pure value and 50% pure momentum portfolio has the highest risk-adjusted returns across all portfolios.
• In addition, we find similar results when equal weighting portfolios.

Summary

Overall, the evidence suggests that a blended strategy, which combines Value and Momentum into a single unified process, is worse than allocating 50% of your capital to a pure value investing fund, and 50% to a pure momentum investing fund. This may have implications for how investors allocate to value and momentum anomalies. Of course, one must consider that we have only analyzed simple value and simple momentum strategies. Perhaps there are more sophisticated techniques to make “blended” val/mom better than allocations to pure value and momentum. Some evidence from other authors finds conflicting evidence. We’ve done our own extensive testing reconciling the various findings, and we think the analysis above highlights in a SIMPLE way that combo portfolios are relatively better than blended portfolios. That said, we are open to additional input and testing from the broader research community.

Please share your thoughts and insights.