It may sound like the combo of peanut butter and salami, but combining value with momentum actually works, and these two funds are proving it, notes Samuel Lee of Morningstar ETFInvestor.

Depending on your perspective, Russell’s new momentum exchange traded funds are either useful or utterly insane. Every month, like clockwork, the ETFs buy the hottest, best-performing stocks and dump laggards.

It sounds like a surefire recipe for buying high and selling low. Yet a naive momentum strategy has generated market-beating returns over long time periods in almost every stock market studied.

The ETFs come in two flavors: Russell 1000 High Momentum ETF (HMTM) and Russell 2000 High Momentum ETF (SHMO). Just as their names imply, they screen for high-momentum stocks in either the large-cap Russell 1000 or the small-cap Russell 2000.

Every month, the ETFs rank stocks by their cumulative returns over the past 250 trading days, excluding the past 20 trading days. The best-performing stocks are chosen until the target portfolio has a total capitalization of 35% of their respective universes.

Momentum, or the tendency for performance to persist over the medium term, is an anomaly in the sense that traditional theories don’t do a good job explaining it, nor why it still persists decades after its discovery. After all, if everyone knows about a market-beating strategy, they’ll arbitrage it away.

Thankfully, we’re not flying blind here. A great deal of brainpower and ink has been spent uncovering its mysteries.

Why Does it Work?

Narasimhan Jegadeesh and Sheridan Titman are credited by academics for discovering momentum, though practitioners had been exploiting it for decades by the time the duo’s study came out in 1993.

The pair found that a simple long-short strategy that every month bought the top 10% of best 12-month-performing stocks and short-sold the worst 10% of 12-month performers earned excess returns of about 12% a year.

Subsequent research has uncovered momentum in virtually every market studied, including commodities, currencies, stocks, and bonds, and over wide-ranging periods. Thanks to this rich body of research, we have a good idea of why momentum exists and how it behaves.

The most convincing explanation lies with behavioral biases, rather than rational, risk-based theories.

In light of surprising or extreme news, investors may "anchor" new price estimates to old prices, preventing prices from fully reflecting new information. Investors are also loath to realize losses, preferring to keep dogs until they break even, and are too quick to sell winners.

Both biases prevent prices from instantly reflecting new information; instead, prices slowly adjust to fair value, creating sustained price movements. Once a trend is established, performance-chasers hop on. The trend eventually collapses after the market realizes it has overshot.

NEXT: Momentum’s Momentum

Momentum’s Momentum

Momentum probably hasn’t disappeared because the severity of the strategy’s losses means leveraged momentum strategies eventually get wiped out, discouraging institutions from arbitraging it away.

Even if it doesn’t wipe you out, momentum hurts you at the worst possible time. The Russell-Axioma US Large Cap High Momentum Index, HMTM’s benchmark, lost a staggering 48% from June 2008 to March 2009.

The strategy can also be a self-fulfilling prophecy, accentuated by investors who try to exploit it. Since momentum’s discovery, it’s actually become more powerful and volatile, at least in the US stock market.

We’ve seen evidence of momentum strengthening across asset classes in recent years.

It’s unlikely that momentum will disappear anytime soon, owing to its risks, the universality of psychological biases, and structural limits to arbitrage. But it may become more volatile, and perhaps less profitable, as investors pile in.

Two-Faced Unreason

Given the strategy’s nasty blowups, why bother? AQR founder Cliff Asness demonstrated that momentum pairs well with value, muting some risk.

According to AQR, from 1980 to 2009, a simple large-cap momentum strategy (very similar in construction to HMTM’s) had a correlation of about negative-0.50 to the Russell 1000 Value Index. It’s rare to find two positive-expected-return long-only stock strategies with negative correlations, let alone ones that have market-beating returns themselves.

He argues that value and momentum are opposing manifestations of behavioral biases. In Value and Momentum Everywhere, he, Tobias Moskowitz, and Lasse Pedersen find that value and momentum share this negative correlation structure across asset classes and geography.

The study lends strong support to Asness’s original thesis. We agree that when paired with value stock exposure, momentum becomes much less dangerous.

Value and Momentum in Practice

The simplest way to implement a value and momentum strategy is to split your equity allocation in half and rebalance regularly. Russell 1000 High Momentum ETF pairs well with Russell 1000 value ETFs like iShares Russell 1000 Value (IWD) and Vanguard Russell 1000 Value Index (VONV).

Russell 2000 High Momentum naturally fits with Russell 2000 Value ETFs. Historically, however, Russell 2000 funds have lost lots of money due to synchronized buying and selling of relatively illiquid small-cap stocks during index reconstitution periods.

Some may prefer less popular small-cap value ETFs like WisdomTree SmallCap Dividend (DES) and PowerShares FTSE RAFI US 1500 Small-Mid (PRFZ) as substitutes to the Russell value funds.

Braver investors can overweight small-cap momentum and value ETFs. Small-cap stocks tend to drive much of the excess returns in value and momentum strategies.

Not the Holy Grail

Unfortunately, value and momentum aren’t slam dunks. The ETFs available don’t fully exploit the value and momentum effects. The most value- and momentum-laden stocks tend to be small and relatively illiquid.

You probably won’t reap anything close to 12% annual excess returns, as Jegadeesh and Titman found. Frictional costs, taxes, and capacity constraints all conspire against investors seeking to exploit the phenomenon.

At the very least, investors should keep the momentum funds in tax-sheltered accounts, lest they run the real risk of paying taxes on short-term capital gains distributions. We wouldn’t be surprised to see a value and momentum strategy only modestly outperform the market net of fees.

Subscribe to Morningstar ETFInvestor here…

Related Reading:

Related Articles
  1. Stock Analysis

    Will J.C. Penney Come Back in 2016? (JCP)

    J.C. Penney is without a doubt turning itself around, but that doesn't guarantee the stock will respond immediately.
  2. Stock Analysis

    Allstate: How Being Boring Earns it Billions (ALL)

    A summary of what Allstate Insurance sells and whom it sells it to including recent mergers and acquisitions that have helped boost its bottom line.
  3. Economics

    Long-Term Investing Impact of the Paris Attacks

    We share some insights on how the recent terrorist attacks in Paris could impact the economy and markets going forward.
  4. Options & Futures

    Cyclical Versus Non-Cyclical Stocks

    Investing during an economic downturn simply means changing your focus. Discover the benefits of defensive stocks.
  5. Investing Basics

    How to Deduct Your Stock Losses

    Held onto a stock for too long? Selling at a loss is never ideal, but it is possible to minimize the damage. Here's how.
  6. Economics

    Is Wall Street Living in Denial?

    Will remaining calm and staying long present significant risks to your investment health?
  7. Stock Analysis

    When Will Dick's Sporting Goods Bounce Back? (DKS)

    Is DKS a bargain here?
  8. Investing News

    How AT&T Evolved into a Mobile Phone Giant

    A third of Americans use an AT&T mobile phone. How did it evolve from a state-sponsored monopoly, though antitrust and a technological revolution?
  9. Stock Analysis

    Home Depot: Can its Shares Continue Climbing?

    Home Depot has outperformed the market by a wide margin in the last 12 months. Is this sustainable?
  10. Stock Analysis

    Yelp: Can it Regain its Losses in 2016? (YELP)

    Yelp investors have had reason to be happy recently. Will the good spirits last?
  1. How do dividends affect retained earnings?

    When a company issues a cash dividend to its shareholders, the retained earnings listed on the balance sheet are reduced ... Read Full Answer >>
  2. What is the difference between called-up share capital and paid-up share capital?

    The difference between called-up share capital and paid-up share capital is investors have already paid in full for paid-up ... Read Full Answer >>
  3. Why would a corporation issue convertible bonds?

    A convertible bond represents a hybrid security that has bond and equity features; this type of bond allows the conversion ... Read Full Answer >>
  4. How does additional paid in capital affect retained earnings?

    Both additional paid-in capital and retained earnings are entries under the shareholders' equity section of a company's balance ... Read Full Answer >>
  5. What types of capital are not considered share capital?

    The money a business uses to fund operations or growth is called capital, and there are a number of capital sources available. ... Read Full Answer >>
  6. What is the difference between issued share capital and subscribed share capital?

    The difference between subscribed share capital and issued share capital is the former relates to the amount of stock for ... Read Full Answer >>

You May Also Like

Trading Center