(Bloomberg) — It’s the classic attack from market pragmatists on quant investing: Stock trades that look smart in theory end up misfiring in real life.
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And researchers from the Federal Reserve and the University of Calabria in Italy are now the latest to pour skepticism on the popularity of systematic funds that chase recent winners and dump losers, part of the so-called factor-investing boom.
These momentum products have delivered subpar risk-adjusted returns relative to the broader market since 2015, per a new paper from authors including Fed economist Ayelen Banegas. Whether it’s elevated transaction costs or design flaws, the performance is so linked to the market overall that their diversification value is found wanting, the research argues. Put simply, these funds aren’t offering investors anything special.
“I’ve seen a lot of hype about factor investing,” Carlo Rosa, Banegas’s co-author and an assistant professor at University of Calabria, said by phone. “But for an investor, it seems that the economic value of momentum funds is not great.”
The paper isn’t a direct rebuttal of the virtues of the momentum strategy itself, which was pioneered by firms like AQR Capital Management. Each quant executes the strategy differently and many only use it as part of a broader multi-factor portfolio. But the research contributes to the raging debate on whether quantitative investing via mainstream funds has become over-hyped.
Using an approach known as smart beta, portfolios slice and dice the market using indexes tuned to classic investing factors like momentum in a bid to outrun the market. A multi-year proliferation has seen smart-beta’s presence expand to almost a quarter of the $7 trillion market of exchange-traded funds.
Like the rest of the industry, momentum strategies have seen exponential growth, with assets expanding at a rate that’s three times that of conventional funds since 2006.
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As popular as they are, their performance is far less impressive. Momentum funds generated negative alpha, or below-market returns, during the last six years, according to the paper titled “A Look Under the Hood of Momentum Funds.” For investors already with money in portfolios based on the original Fama-French factors, adding momentum to the mix did not improve performance much either simply because its return was largely brought about by the overall market.
There are lots of possible reasons for their rough record, from the way they’re constructed, to the costs of transactions and management fees. Or simply badly timed rebalancing. Because many funds only shuffle their holdings quarterly or semi-annually, they’re at risk of failing to keep pace with the market.
The iShares MSCI USA Momentum Factor ETF (ticker MTUM), for example, had a lackluster first half of 2021 after being slow to switch into more economically sensitive shares that were benefiting from bets on a rebound from the pandemic. By the time it had caught up to the market rotation, those cheap and cyclical stocks were in retreat again.
To Banegas and Rosa, another key issue may be at play: the poor performance of the momentum signal itself.
Factor models set forth by academics Eugene Fama and Kenneth French are meant to have both long and short positions. Historically, about half of the momentum style’s alpha stems from the long side, and the other half from the short side. That’s the case over the period from 1927 to 2014.
Since then, however, momentum’s performance has been almost entirely driven by the short side of the portfolio, the authors found. That means chasing winners has stopped working. That happened partly because so much money has piled into the same stocks, like technology shares. And when these equities dominate benchmarks, it’s hard to gain an edge by going after them.
The distortion doesn’t bode well for funds that are restricted from making bets against stocks. Nevertheless Rosa admits that the long side of the trade’s misfiring could be temporary.
“I only looked at six years data and it may not be long enough to completely lose confidence,” he said.
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