The. This is a QR's curious investor a show, the breaks, down some of the most important ideas and finance to help us make better investment decisions. I'm Dan Bill, and I'm gave the galley. Welcome to season to everyone. We're kicking things off by talking about momentum. What it is why it works. And why it's so hard to stick to momentum is a big area of research for academics and practitioners and today's guests are kind of both they got their PHD's from the university of Chicago. And both use momentum themes to manage real world portfolios. My name's west gray, I'm CEO of alpha architect, high cliff, Agnes, managing principal, and a co founder at a QR momentum at its core is pretty straightforward. If security has done well over say the last, twelve months, you buy it. If it's done poorly, you sell it piece of cake, but things get a little trickier once. You get into the details, here's Wess if you talk to people about momentum in our business. It means so many things to so many different people. If you talked in academic momentum means relative strength. Whereas if you talk insane momentum to practitioner, a lot of times think you talk about trend falling or time series momentum, which is where you got a single security measured over two different time periods. Here's an example of the difference trend following or time series momentum is about looking at a security by itself, so suppose the S and P five hundred is up ten percent over the past twelve months trend followers would be bullish. And let's say the u k footsie is also up, but only five percent trend followers would also be bullish what it's different in relative. Strength momentum there you've still be bullish on the SNP. But this time bearish on the footsie because the footsie, underperformed, the SAP, even though they're both up. We'd care about their relative performance and this is the type of momentum. We'll be talking. About today? Some factors like value and quality have been around for a long time Benjamin. Graham wrote about investing in cheap high-quality, stocks almost a century ago, the momentum factor is a lot newer to the game. Okay. So you were one of the first folks do in academic treatment of momentum. And it's wondering if you could kind of bring yourself back to the late eighties early nineties. What got you thinking about it in the first place. First of all, it's a little depressing because I had a beautiful head of hair at that point. So we're going to go back that time, I, I gotta get past that, you know, we always talk about data mining just looking for patterns to be dangerous because you can discover random patterns and then you don't know if they're real I do think the in all honesty. The initial momentum results were largely observational in that led cliff to do a little more digging. It's one thing to stumble upon some pattern that seems to generate returns. It's another to understand why and publish about it in nineteen Ninety-three, Narasimhan Jagdeesh, and Sheridan Timon wrote a groundbreaking paper on momentum in the journal of finance, I give Jagdeesh tip and full credit for being first. But I was very contemporaneous with them just sitting alone in my dorm room as a grad student, the momentum that cliff was looking at is often called one. Year. Momentum basically looking at returns over the past year. Excluding the most recent month. His data started in nineteen sixty three and went through the eighties and Dover that sample the returns to this momentum strategy looked pretty good. Rick, then cliff got his hands on a new data set one he hadn't looked at yet that date. It was like a prequel it started in nineteen twenty six and ended in nineteen sixty two I actually got a little bit of a chill. This is the closest financial research comes to high-drama the one year momentum result was approximately as strong was very excited. Part of what makes a factor viable is that it needs to work over long. Periods of time. It also needs to be pervasive. And momentum seems to work in a bunch of different asset classes like commodities fixed income equity indices, and currencies just to name, a few and no fence to cliff. But the thing that I always found odd with momentum is that it's such an easy. Strategy. You basically look at returns over the past twelve months, things that did better than average you like and things that did worse than average. You don't like doesn't really seem like something that requires a fancy academic background to get right? But west gray CEO of alpha architect says it's deserving of hardcore study. And he uses the concept of gravity to make his point. We all know how gravity works if I take an apple and I drop it. It'll go and hit the earth. Great, anyone can do that. Anyone can implement that, but the issues it takes someone like Newton or Einstein actually understand, will why does gravity actually work. So I think momentum might be the same thing where if you just want to implement momentum. It's not that hard, you don't need a PHD too short securities on their past performance, but work, it's difficult is trying to understand. Why does momentum work in in? That's where, you know, you need research skills and ability to. Think deeply about what seem simple because we all know it works. But we may not know why it works. This brings us to one of the most important things you can ask of an investment strategy. Why does it work? And while there can be lots of possible explanations. They can generally be grouped into two categories risk-based and behavioral. The risk base camp says you get paid for investing in a factor because it's risky. Take value as an example, cheap companies are cheap for a reason those companies might be the first to go out of business when the economy suffers so you'd expect, hey, you're taking a big risk. You should get a bigger reward. But the behavioral camp says no, cheap companies aren't riskier. It's just that were humans and his humans were not that good at knowing the right price of a cheap company, and there can be a bunch of reasons. Why like a company whose price has been beat up for a few years might just get neglected? People are talking about it less. They're less interested in it, sending its price lower than it should be when it comes to value. Both the risk and behavioral camps, have pretty good explanations. But momentum is different. There aren't that many intuitive risk based explanations for it. That means most people tend to favor the behavioral ones. Let's start with under reaction. Here's cliff. When news comes out, you do incorporate that new news. But you move off your prior beliefs. Maybe slowly, the price will move. But if the market as a whole exhibits this tendency, it will move less than the new information really warranted. It'll be all right. We see it, but we're gonna move part of the way if that's the case you get a simple momentum effect. Good news on average leads to price going up on average price doesn't go up enough. So an average when you see price going up, it probably wasn't quite enough. This underreaction story is related to news, but investors can also under react to changes in fundamentals. Some classic examples are earning surprises. Analysts provision to earnings that is a beautiful under reaction story. Now, I will tell you under reaction is my favorite story. Not my favorite like I find it most aesthetically pleasing. The one is the one, I think most likely. To be true or or contribute the most, but one of the other major explanations for momentum embarrassingly has the opposite terminology lease. But as overreaction many think of momentum as far as people chasing price there you can build that into models to show that if people overreact that can lead to momentum, another behavioral reason is related to the disposition effect, which is that people tend to dislike losses more than they enjoy gains. This is the, the pretty well documented tendency individual investors do this. They are very willing to sell winners in hold onto losers. And that is a call it a psychological bias, but it's kinda neat. When you think about that. What would that would lead to if you are absolutely quick to sell winners? When good news comes out, they'll be selling pressure against it again. It was real news. So eventually, it's gonna. Get into the price. It's a way of, of, of slowing down that move the people who react that way might actually create momentum profits, because they're keeping the price from jumping all the way west has another explanation for momentum. And that is reflexively. So fundamental guy says, okay? Fundamentals drive the price, right? If the fundamentals are doing better, eventually, Mr. market agrees, with me in the price will move to what I say. But what did you invert that question, and said, what if prices actually influence fundamentals, how might this work? Think about a company whose stock price has recently gone up a lot compared to its peers. It's cost of capital is probably now a lot lower. Now say wants to acquire another company. Well, that's a bit easier with their newly inflated stock price. How 'bout tracked and talent what kind of engineer who's probably? I'm not a finance expert. They just look at the stock price assess how great amazing this company is like, yeah, I wanna work there. Those options are probably gonna be worth a lot. So maybe there's, there's a billion detract human capitals, because your fancy, you're hot. You're out there. If you think about it reason out performances, great PR that can further as a, stock's price over time allowing momentum investors to profit. We've talked about a few of the behavioral explanations from a mental, but there are a few risk-based wants to if you're an investor which explanations should you prefer? There's no clear answer. But I'll tell you the good and bad parts of both if something works because it's risk your first best. Guess is it's going to work forever is compensation for bearing risk. There's no real reason. It should go away. That's the good news. The bad news on this is I apologize in advance for the obviousness of this. But if it's risk than it's risky risk is something that hurts, you that you don't want to bear if it's behavioral you get precisely the opposite. It's not adding over time to the risk of your overall portfolio, and you expect to make money long term. That's wonderful that's better than a risk premia because who the heck doesn't want money without fear. The problem, of course, is it is more. Susceptible to going away if something works because investors make errors. It can go away for two reasons. They can stop making those errors or too many people can try to exploit those errors. I guess I'm rooting for a behavioral premium that takes a long time to go away. Luckily that, that does appear so far to be the leading contender, and to be entirely clear, the world doesn't really give a darn what I root for going to be. It's going to be what it's going to be. Cliff raises a point about investors wising up to a factor and piling in which leads to a big question if everyone knows about momentum and if it's due to behavioral by sees you'd think it'd go away. Here's west is take. Why would we write books in might be super transparent about the exact nuts and bolts of the strategies, we run that seems insane, right? Because we know a little secret. We're doing is difficult to actually employ impractical. I say no pain, no gain in marines. This extreme pain, extreme gain it's probably worth mentioning that west was US marine for four years before getting his PHD. He was also training for a one hundred mile ultra marathon when we met him he knows about pain, and momentum even if it's just a behavioral mispricing can still be painful. This might be a big reason why it's not getting arbitrage away. So there's a twenty dollar Bill on the ground. But there's a grizzly bear that standing next to it so clear. This is miss price. Right. Why would you have a twenty dollar Bill sitting on a frequent ground, but there's a grizzly bear. Staying over it. So, so sometimes in the marketplace, there's an open secret. There's a twenty dollar Bill on the ground. Go for it. There's a grizzly bear on top of it. And that grizzly bear might be career risk. It might be arbitrage risk. You may be frictional cost. Whatever. West stakes is metaphor. So seriously, that he actually has a taxidermy grizzly bear in his office. It's called the Grizz and it was terrifying. Another thing keeping investors from facing off against the Grizz is that momentum is harder for most fundamental investors to get their heads around. I don't think it's as intuitive or feel good as value like value makes sense. You get a buy cheap stuff. It's down. You're not the sucker. Right. But who wants to look? At a stock chart at its fifty two week high and be like, oh, I want to buy that, right. That's not intuitive. Like I don't wanna be the bag holder, even cliff a guy who's been managing momentum oriented strategies for nearly three decades agrees a joke, I made for probably about two years to one of my co founders of accu- are John Lew. He probably wanted to kill me for making the same joke over and over again. I'd say, John, are you telling me, we are buying more of the Japanese yen, because its price is higher than last month? And John would just look at me, deadpan and go. Yes, that is what I'm telling you. And I think part of it is, is while I think there are good behavioral stories for it, it, it does not have the same to it of buying that, that value has. And like all factors momentum can have some painful drawdowns momentum has in an industry parlance. Two very anodyne way to put it as has left. Tail is negatively skewed which kinda rhymes with how you actually feel at those periods and just to define that the world. Rarely follows a perfect normal distribution something very close to the famous bell curve, where two standard deviation events or rare three are very rare. And for only happen in nightmares. No, the real world tends to be somewhat fat tailed, meaning big events happen. More often a portfolio of momentum stocks. Particularly long short long winner. Short losers has undeniably had a big left tail it has crashed most notably in the spring of two thousand nine as the global financial crisis abruptly stopped and reversed no matter how much you try to construct your portfolio. Well, a short sharp reversals of strong trends, I, I don't think I need to belabor that, that seems like the obvious time momentum going to get hurt. The what should matter to investors isn't just that one factor can underperform. It's whether others can be there to pick up the slack. So let's go back to two thousand nine value, by the way, did well enough that a whole portfolio of both factors was not particularly distressed. One of the things that makes momentum so special is that it tends to work really well, with value. When one's doing worse than normal, the others doing better than normal, statistically value and momentum tend to be negatively correlated, which kind of makes sense if you'll imagine buying stuff, or good stuff is going on lately, and another strategy is buying stuff in some distress, that's reflected in the price. I don't think most people require giant intuitive leap to say these appear to feel like different strategies the momentum value correlation a call. It minus point six and fairly reliable. That is a huge number meaning if you're gonna do both they're both better than viewed alone. In fact, more and more over time I prefer to think of value in momentum as a system, you might think given the diversification benefit and combining value momentum. Everybody would be doing it, but they're not and west has theory for why like people that do value or stuck on fundamentals stuck evaluation, people that do momentum. Just look at prices and charts but I liked that. Because just structurally different worlds in the market, which means they also should have pooling benefits but for anyone who's a value investor. They don't believe in the religion of price trend momentum because, you know, Ben Graham told now's a bad idea that the great irony is, they're the ones that could maximally benefit from the dishes momentum. But the problem is they've got to get over the behavioral issue of being so faith based in, in one school thought. In that maybe you can't break that. It's tempting to say okay in this environment, I'm gonna put all my eggs in the momentum basket. And in this other environment, I'm going all value west says to think twice before giving up that diversification the issues, I I'm going for two birds in the Bush as opposed to the one bird. I know in my hand because the bird, I have in my hand when I roughly take equal risks from value momentum is known structural diversification. Right. So I know I'm going to get that. If I stick to these things, the minute, I start, tilting them like, oh, let's just do more value. Not that much momentum. I give up the known structural correlation benefit that I believe in strongly in I get the potential benefit of maybe better expected return by tilting. More to one versus the other and yeah, you can back test. You're blue in the face to show me that factor timing works. But you're kind of risking the one thing we. No earliest, I believe more strongly end than factor. Timing is the diversification benefits. A common knock on momentum. Is that it's expensive to trade the way you get that strategy working? Unfortunately, is it's gotta have turnover in. It's gotta be rebound. Right. You always gotta be recycling of these high momentum names. And the problem with that is ninety got tons of frictional cost. A lot of investors questioned whether momentum even works after all these costs. Well, the answer's yes, it doesn't work as well. Nothing works as well after after cost fees and taxes. They're, they're those three rarely positives. There are critics of it, who point to its turnover and say, look, the prophets may be wiped out. We think they go way too far to prove his point ache, you are published a paper called trading costs, which reports live trading costs for running momentum strategies, but even more important for investors is it can get cheaper to trade momentum. When you combine it with other factors again particularly value in momentum often. One is buying what the other is selling. And you know what the cheapest trade on earth is, is the one you don't do. So the point I think, is even stronger in a in a multi factor world. So let's recap momentum is a source of returns founded many asset classes, and over a long period of time, we can call it a factor because there are many economically intuitive explanations for it. These include under reaction in news, the disposition effect and reflexively. But it's benefits. Don't come easy like any factor momentum can have its periods of pain. But that might actually be a reason. The momentum premiums sticks around. We all know what works by pain. Be disciplined by cheap by strong, you know, put it in a Bank account minimize fees minimize taxes and wake up thirty years from now. Great. The problem, though is being able to stick with them. Right. So why education, we think is so important is if I'm gonna get you in something that I know, has a high probability of working I need to make sure that you yourself or defense up. So inevitably one, there is the real pain. You don't look to me is like, hey, you're the guy. Why is this not working in, so that's why the focus is on education to the end client, because we want to have education in order to make you more sustainable. We've got your back on that one with for listeners who want. To learn more about momentum head over to a QR dot com slash curious where we posted a few papers on today's episode. And if you want to keep this episode. It's momentum going. You can Email us at curious at a QR dot com. Next time, we'll talk about commodities trends, and turtles, I think pork bellies stopped trading in twenty eleven which is kind of funny because I think it's the go-to of everybody like when you say commodities, they're like, yeah, you trade pork. Bill. Not since twenty one. You stayed curious listeners and watch out for the Grizz. You have to fight a damn grizzly bear is scratches on your back. Right. You get like even by the same maybe time for one more. Well, one thing we didn't do I never actually gave you any of the behavioral explanations for. Oh, yeah. Meant them. Fill it, somehow we veered. So it would be great. It's yeah. I don't need too much on this. But go yeah. Asked me to can you give us one or a few behavioral stories behind why momentum might exist. 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