ETF Expert Corner
Alpha Architect’s Wes Gray Spotlights Momentum ETFs
January 12th, 2016 by ETF Store Staff
You can listen to our interview with Wes Gray by using the above media player or enjoy a full transcription of the interview below.
Nate Geraci: The ETF we're spotlighting this week is the Momentum Shares US Quantitative Momentum ETF. The ticker on that is QMOM. This is offered by Alpha Architect, and joining us via phone from just outside Philadelphia to discuss this ETF, is Wes Gray. CEO and Chief Investment Officer at Alpha Architect. Wes as always, a pleasure to have you joining us.
Wes Gray: Hey gentlemen. Thanks for having me on the show, I appreciate it.
Nate Geraci: Wes we've had you on the program before to talk about value investing. Of course value investing has proven to be a market anomaly. Where investors can potentially earn better risk adjusted returns. Another market anomaly appears to be Momentum, and I love sports analogies. In a piece you wrote you say, "That if a basketball player hits several shots in a row, the commentators say he has a hot hand. In finance that's momentum." Can you elaborate on this for us? How do you explain what momentum investing is? Just to the lay person.
Wes Gray: Sure, so most people know value and a lot of times the typical reasoning behind why value works is that it's essentially defined as an overreaction to poor short term fundamentals. The irony is that a lot of people who are value investors think that momentum investing is insane, but when you read the behavior on momentum investing it's essentially a under reaction to good short term fundamentals. Classic momentum strategies, when we're talking about this at the stock selection level, they really have relative strength strategies and they just recently in the last 20 years have been called momentum strategies. All you're doing is if you have 1,000 securities at the most basic level, you sort those securities on say their last 12 month returns. You want to, at least the evidence suggests, that you want to focus on the top 100 stocks that have the highest relative 12 month returns, and avoid securities that have the worst relative 12 month returns. That's at the very essence of momentum strategies, which it's probably better to call them relative strength but people don't do that anymore. That's how the strategy works.
Jason Lank: Good morning Wes. This is Jason Lank. You mentioned that some of the reasoning behind why these factors work, are over reaction, or under reaction by investors. It sounds like I should have gotten a psychology degree instead of a business degree. Do people under estimate or under appreciate the effect that investor behavior has on these factors?
Wes Gray: I think so. Like momentum is actually a really counter intuitive one. Again it goes back to value. It's against a religion. Even Warren Buffet says, "Why would you get excited when a price goes up?" For many respects that's actually a really good point, but what's interesting about momentum strategies is the evidence is actually even more compelling that momentum is more of an anomaly than value investing is. A lot of academic research is focused on, "Well why is this?" If it is an anomaly, it's obvious that it has to be derived or based in some sort of behavior biased problem. Of course a lot of people have done a lot of follow up research, and most of the explanations for momentum are, there are some institutional reasons, but it's all about investor behavior. Disposition effects. You're supposed to let your winners ride and cut your losers short. What do people really do? They cut their winners short and let their loser ride. You can tell people until your blue in the face that you should follow the mantra, because it actually works, they just don't do it, because it's buried in monkey brain to have a disposition effect.
Nate Geraci: Wes, so Alpha Architect recently launched two ETFs that attempt to capture this momentum premium. These both follow the same process, so let's focus on the Momentum Shares US Quantitative Momentum ETF, ticker QMOM. Tell us what this ETF does.
Wes Gray: Sure, so what we're trying to do is essentially deliver an active momentum factor that we think is the best agreed approach to actually exploit that anomaly. At just real high level, when you think about momentum and you look at the actual evidence on how the strategies work, there's two things that drive the performance at a real high level. One, the number of securities in the portfolio, and then two, the turnover of that portfolio. It is literally systematic. Where if you have more concentration and higher turnover, momentum strategies at least from a historical perspective, will have higher performance. We're talking about gross right here right? Of course a lot of that is driven by frictional securities, and scalability. If you want to set up a fund that's going to have huge scalability, you can't hold 50 stocks. You've got to hold 250 stocks, because now instead of a billion dollars I can jam 20 billion dollars into this strategy.
Similarly when it comes to turn over, one could re-balance that portfolio every month, but that would incur a ton of frictional cost. They could in every quarter. They could do it every year, but there's a trade off. More turn over more returns, but also less scalability and more frictional cost. How we've designed our product, in this momentum space specifically, before we even talk about how we think about how to do momentum, is we're going to understand that structurally the portfolio is aiming to have 50 securities. Which is a trade off we've decided up front. We're not going to have huge scalability and we're going to have a ton of tracking error, but we're going to at least deliver on the active benefit of momentum. If that does exist. Then as far as turn over, we've chosen to go quarterly essentially and then we exploit some seasonality effects. We're not going to go monthly, because it's just a frictional cost and operational risk is too high to do that, but quarterlies still capture most of it without destroying the expected returns net of cost. More concentrated, reasonable turn over, that is two ingredients that have to be included in any momentum strategy.
As far as how is our momentum strategy any different than just generic relative strength on the past 12 months, well there's basically two muscle movements that we're exploiting. One is the past dependency of momentum. If you read all the research out there on how to use momentum as a stock selection tool, one of the reoccurring themes is that how that momentum is formed tends to predict whether that momentum will continue in the future. What do I mean by that? If we have a bio-tech that's up 100%, because it just got FDA approved yesterday, and then we have another firm that's some boring whatever manufacturing firm that's gone up 50 bits over the last 200 days. They're both 100% return, and presumably they're both going to be in the category of high momentum securities. However, how that momentum was created, the path dependency of it, is much different. The bio-tech just shot up once in a day. The other one kind of was a slow grinder.
Well it turns out that however you determine how you're going to quantify that, it's that those slow grinding momentum stocks tend to be the ones that continue to grind with positive momentum in the future. Whereas these high momentum stocks, that are just volatile as heck, on average they tend to be essentially efficiently priced. They're not going to gain huge benefits over just buying a vanguard fund. We exploit that core element as a key differentiator in our momentum process.
Jason Lank: Wes, several of the steps in your investment process that you described. Number two, generic momentum screen. Then you screen for quality. I think that's what you're referring to in the shapes of the returns. Is that what you mean by quality momentum?
Wes Gray: That's what I mean. You can go out there and buy generic momentum. Which for ease, is for the last 12 months, rank all the securities by the ones that had the best 12 month momentum. We're looking for the quality of that momentum, because not all momentum is essentially created equal. That's what's in academic research. That's what our own research indicates, and we're just more evidence based folks, so that's what we do.
Jason Lank: The next step now is a momentum seasonality screen. Would you make the case that momentum varies by Spring, Summer, Fall, Winter?
Wes Gray: Not exactly that, but yes it definitely has seasonality effects. It's not me making the case, it's just this is what the evidence suggests and what the research suggests, and basically what it is, is it's driven by two factors. One is a thing called window dressing. Which if you're unfamiliar, there's a ton of research in the mutual fund space ... A lot of times what a manager wants to do, is even if they've picked the wrong stocks, when they post that quarterly report, they want it to look pretty. They want it to have a nice window dress on it. You don't want to ... Even if you pick the bad stock on 3/31, you want to make sure that whatever you post on you official filing looks good. What happens is usually the stocks that "look good" are high momentum stocks. There's kind of this, I guess, flow activity. Where mutual funds want to window dress their portfolios, which is going to occur right before a quarter ends, and so momentum effects are really strong basically if you front run this institutional flow for window dressing.
If you form those momentum portfolios at the beginning March, the beginning of June, the beginning of September, and the beginning of December as opposed to the end of those months where the window dressing effect has already taken place, the premiums are much higher. Then general momentum premiums in those off kind of front running the window dressers, they're not that high. They're non-existent. It's all about basically front running the flows, the window dressing. Then another element, that is really important especially in US securities towards the end of the year, is obviously the tax element. Which is much more intuitive, because in November and December if you a have high momentum stock, it's a stock that's gone up. You're probably not going to want to sell that right at the end of the year, because you're going to have to pay taxes. Same thing, low momentum securities are your losers, so you're going to want to sell those at the end of the year to kind of book your tax loss. Momentum is magnified at the end of the year.
Then it's actually weird, but in January, it's actually the one month where momentum strategies actually have poor performance. The argument is that what's happening is tax loss traders are basically unwinding those trades. Where they're now selling the high momentum, and buying back into their low momentum names they didn't like. Other than that momentum's good, but there's definitely seasonality elements to momentum stocks.
Nate Geraci: Wes as it relates to your US Quantitative Momentum ETF, at the end of the day you're seeking a portfolio of about 50-60 stocks with the highest quality momentum. Is that best way to sort of summarize this?
Wes Gray: Yeah. You've got it. We're just trying to exploit within the anomaly in a smart way, so we're focused on quality momentum. Then our re-balance, we're always worried about frictional cost versus expected performance. We've chosen to set up a re-balance to basically exploit the seasonality effects that I'm talking about. We're essentially front running window dressers. Our re-balances are right before those quarter ends. A few weeks before, because we want to try to get ahead of institutional flows on these high momentum names. Where we know just organically and not really related to fundamentals, you're going to see capital flows come into these things. Just because people want their books to look good on the quarter marks.
Nate Geraci: Now I mentioned you launched two momentum focused ETFs. The other is the momentum shares International Quantitative Momentum ETF, ticker IMOM. You use the same process here. This just holds international stocks, is that correct?
Wes Gray: That's correct. We do the same core concepts, but applied internationally. You got it.
Nate Geraci: Again we're visiting with Wes Gray. CEO and Chief Investment Officer at Alpha Architect. We're spotlighting their new momentum shares ETFs. Wes anytime we look at investments or strategies where there is a claim of potential longer term out performance, we always ask the question of why isn't everyone else doing this? I'll ask you this question. Why aren't more advisors and more investors using momentum strategies if they can potentially provide out performance?
Wes Gray: Yeah that's a great question, and we always talk about this idea of what we call sustainable active investing framework. Where if you can't identify who the worst poker player is, and you can't identify who the best poker player is, you don't really have an edge. In momentum, we're of the opinion based on the evidence and based on some of the psychology research, that there are a lot of bad poker players that transact in momentum stock. That creates the opportunity, but then the second question is, well fine why the hell isn't everyone else doing it if everyone can hire a bunch of PhDs and figure this out as well? Well momentum strategies, especially run with how we run them, which is concentrated with a ton of tracking error and we're literally just taking on massive career risk, because these strategies will deviate from standardized bench marks by extreme amounts. A lot of capital out there, that manages capital on behalf of other people, they're weary about going down that route because if you deviate too much from a standard bench mark over a certain horizon, you're not going to have a job anymore. We've just chosen to say, "Well fine we're just going to do that on purpose and go identify the capital that actually has long duration, long horizon."
That essentially is the real edge, because there's way more capital that short horizon kind of bench marked focused, and a lot less capital that's focused on exploiting long term long duration anomalies. We've just designed our strategy to be very typical for huge institutional, short minded, consultant driven, short horizon bench mark focus. They're just not going to want to do these things. It's just volatile as hell. Which also prevents people form doing it.
Risk adjusted, it's just a great long term bet in expectation, but in the short run momentum strategies are going to make people want to dive off the cliff at certain points. That's part of the reason why it works. It's really hard to arbitrage and really hard to stick with. Our stuff is definitely not for everyone.
Nate Geraci: Wes we have about a minute left. I was going to ask you, is that the biggest risk to momentum investing? Just this potential for higher volatility, maybe bigger potential drawdowns?
Wes Gray: Yeah definitely. Momentum investing is you're catching a lot more potential expected return, but you are definitely eating higher expected max draw downs. Obviously you probably want to deploy, and use the ETF as maybe a tool in a broader context. Where you do trend following or some sort of tactical rule. By in whole, momentum is ... Yeah that's a challenge. I mean it's a great strategy if you generally have tenured horizon and you can eat big draw downs and compound out of that, but a retiree is not going to put all of their money in a momentum fund. That would be tough to say the least.
Nate Geraci: Wes we'll have to leave it there. As always we greatly appreciate you joining us today. A fantastic spotlight. Thank you.
Wes Gray: Appreciate it gentlemen, and look forward to chatting in the future.
Nate Geraci: Thank you.
Wes Gray: Yep.
Nate Geraci: That was Wes Gray. CEO and Chief Investment Officer at Alpha Architect, and you can learn more about their line up ETFs by visiting AlphaArchitect.com.