Sunday, April 24, 2016
Value and momentum - why do they both work?
Two of the most important factors for investors are value and momentum. These are factors that can both easily be exploited and accessed in the market. Value indices are relatively easy to create using a simple set of rules. Momentum is also easy to create through rules or through specific fund styles. Nevertheless, the stories used to explain the excess returns in value and momentum are very different.
A simple matrix based on five criteria can be used to explain the difference between these two factors. The approach of the value factor is to look for cheapness or richness relative to other securities in a portfolio. For momentum, it is looking for assets where there have been high gains versus declines.
For a risk-based story for the excess returns associated with value, there is the view that investors are compensated for risk from firms that may be out of favor. In the case of momentum, there is the story that excess returns are associated with economic trends, the business cycle, or behavior within an industry. Investors are also compensated for the risk of a sharp reversal. The behavioral story for value is based on the idea that the assets are mispriced. Prior risks cause investors to miss the true valuation. The momentum story is that there is a slow adjustment from the inattention of investors. Markets do not react fast enough which may lead to overshooting and then reversals.
With respect to efficiency, value buying attempts to move markets to fair value and thus make markets more efficient. Momentum is likely to be driven by fundamentals that are moving pricing away from existing levels. Momentum in some cases can make markets less efficient by reinforcing behavior which leads to overshooting.
Investors exploit the value factor through their styles of managing their portfolio which we call convergent trading. There is movement or convergence back to fair value. Momentum is inherently a divergent style because there is a movement away from current equilibrium.
The explanation for returns for the value and momentum have been classified as either risk-based or behavioral based. These explanations are fundamentally different. Hence, a value factor based portfolio will be uncorrelated with a momentum factor based portfolio.