The S&P 500 closed at an all-time high yesterday for the sixth straight day. The last time this occurred was June 1997. Why is this happening?
Are markets pricing in tax reform? Is it looking forward to higher earnings over the next twelve months? Is it because North Korea hasn’t been in the headlines for a week or two? You can search for all the reasons you want, but the one that matters is this, rising prices attract buyers. In finance, this is called momentum.
If you looked at the cheapest quintile of an investment universe and sorted on price-to-book, price-to-earnings, or enterprise value-to-EBITDA, you’re going to end up with three portfolios that wind up in a similar range (don’t @ me value nerds). Cheap is cheap however you decide to measure it. Momentum on the other hand can mean different things to different people. For instance, are you looking at absolute or relative momentum? And relative to what? And how often are you measuring this, six months or one year? And how are you weighting this portfolio? And how many holdings are there? And how often is it reconstituted? All of these things can lead to momentum portfolios with returns wide enough to drive a truck through them.
With over $4 billion, iShares MTUM is the largest momentum ETF by assets. iShares uses “A risk adjusted price momentum, defined as the excess return over the risk-free rate divided by the annualized standard deviation of weekly returns over the past 3-years, is calculated for each security in the parent index over 6- and 12-month time periods. The 6- and 12- month risk-adjusted price momentum calculations are then standardized at +/-3 standard deviations and the standardized z-scores are translated into an average momentum score. Approximately 100-350 securities with the highest momentum scores are selected for inclusion in the Underlying Index. The weight of each Underlying Index constituent is determined by multiplying the security’s momentum score by its free-float market capitalization.”
The second biggest momentum ETF is sponsored by State Street. Their fund “Is designed to reflect the performance of a segment of large-capitalization U.S. equity securities demonstrating a combination of core factors (high value, high quality, and low size characteristics), with a focus factor comprising high momentum characteristics.”
We all like to think a good process is preferable to a good outcome, because if you create a repeatable process, you can, in theory, minimize what’s left to chance. But nobody has ever said, “Well the fund is down 15%, but they stuck to their process, which is all that matters.” The reality is that even if a good process will triumph over the long-term, over the short term, we’re driven by results.
State Street may very well have a better process for capturing momentum (I have no idea), but iShares has the performance. You can look under the hood and spend hours and hours determining which fund you think has a better process, but at the end of the day, a fund might outperform for the “wrong” reasons, and process takes a back seat to performance.
Momentum as a factor is still shunned by much of wall street. There are hundreds of billions of dollars invested in value strategies, but the biggest momentum ETF has just $4 billion in it, with $500 million in the next largest. I guess it’s hard to sell the idea that rising prices attract buyers and falling prices attract sellers. That narrative just might not be bullshitty enough. People love a good story and perhaps something this simple doesn’t lend itself to that part of our brain.
Even if investor preferences changes, and momentum’s popularity picks up, the idea that investors herd is so ingrained in our DNA that it might be the only factor that cannot be arbitraged away. And while dyed-in-the-wool, process driven momentum traders might take exception with the methodology that iShares uses to capture it, the results, short-term as they may be, has made result-driven investors very happy.
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