ETF Expert Corner

Wes Gray’s “Quantitative Momentum”

December 20th, 2016 by ETF Store Staff

Wes Gray, CEO at Alpha Architect, discusses his new book “Quantitative Momentum” and explains key factors when implementing a momentum-based investing approach.


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: Let's now welcome in Wes Gray, CEO and Chief Investment Officer at Alpha Architect and author of the book Quantitative Momentum: A Practitioner's Guide to Building a Momentum-Based Stock Selection System. Wes is joining us via phone today from just outside Philadelphia. Wes, as always, great to have you on the program.

Wes Gray: Hey, gentlemen, thanks for having me and happy holidays and Merry Christmas to everyone listening.

Nate Geraci: You too Wes, and you know for the average investor out there, let's first start by explaining what momentum investing is. In your book you say, "The efficient market hypothesis suggests that past prices cannot predict future success, but there is a problem. Past prices do predict future expected performance, and this problem is generically labeled momentum." Provide us some color on this. How should the average investor think about momentum investing?

Wes Gray: You got it. Momentum is real simple. Buy winners, because winners keep on winning. That's the bottom line. It's really nothing more than that to be completely frank.

Nate Geraci: Wes, from an investor behavior standpoint, explain why momentum works.

Wes Gray: So there's, at the individual stock level, there's a lot of research on this. It seems to be the consensus that momentum works because there's a systematic underreaction to news that's embedded in that price, so people are always continually surprised that stock price keeps going up, but good news keeps coming out and it keeps going up and up and up. Then the second element, which you guys highlighted there in the intro is that the incentives of a lot of asset managers is to benchmark hug, essentially look like the S&P 500 and one of the key distinguishing characteristics of momentum, just like value strategies, is they're all over the place. They can be way above the index. They can be way below the index and that element of momentum makes it difficult for a lot of institutional pros to build these strategies and stick with them.

Jason Lank: Wes, you mentioned the phrase, "an underreaction to good news." Help us understand that. If I'm an investor and I see a good earnings report or I see something positive that might bode well for the stock, you're saying that as a whole we tend to act slower on that or we don't fully assimilate the information. Is that what we're talking about?

Wes Gray: Yeah, that's one of the, I'd say the leading theories out there to explain momentum. There's also another one about overreaction, and I imagine the truth is it's probably a little bit of both, but essentially what ... The simplest way to understand it is a lot of researchers they can literally tie momentum back to unexpected earnings releases. What will happen is earnings will come out, they'll be better than expected, and the price will move up, obviously, but it tends to drift. It basically has momentum. This is, it's called PEAD, post-earnings announcement drift, and it's been in the literature. Someone documented it back in 1965 and it's still there. It's this fundamental kind of underreaction to good news that you can capture via proxy just by looking at price behavior and price action.

Nate Geraci: Wes, you began to touch on this, but in your book you say that momentum investing is an "open secret with a track record of over 200 years." If that's the case, why haven't more investors taken advantage of momentum and ultimately arbitraged away any premium?

Wes Gray: There's really two pieces. One, momentum is not for the faint of heart, so there's definitely an element of additional risk and clearly you're way more than compensated for that risk, but it's volatile. Momentum investing is not like bond investing, obviously. Then the second component is because of that volatility and because momentum concentrated portfolios act a lot different than the S&P 500, it's really difficult for a lot of fund managers who have investors that are focused on short-term relative performance to really go too heavy into a momentum strategy because there's a high chance that if they underperform, they'll lose their jobs, so those elements of a lot of additional volatility, i.e. risks will keep it going and also just a career risk associated with long stretches of potential poor underperformance also prevents a lot of capital from trying to arbitrage it away.

Jason Lank: Wes, in your book you talk about how the flow of information and how different kinds of investors receive their information, perhaps the pace and the frequency can in fact affect how they make decisions for their investments. In one case there may be a steady flow, a very drip, drip, drip on a very consistent basis of news, whether it be good or bad. In another situation, there may be that earnings surprise, that shot across the bow. No one saw it coming. You say that even if the information were the same, the delivery, the way it's received can affect decision making. Talk about that.

Wes Gray: That's right, so going back to this underreaction hypothesis that momentum is really this issue where investors look to the marketplace and the price signal keeps moving up a little bit, or there's information released, but for whatever reason they're just not paying attention to it enough, whereas sometimes information is extremely shocking or there's a massive 100% price movement in a day, clearly that does attract attention. One of the things we talk about is this idea of ... It's called the frog in the pan algorithm. It's literally an algorithm that is called frog in the pan and it's a way to look at price patterns and just by using price alone identify those kind of price movements that create momentum that is more likely to be underreacted to versus price momentum that's highly likely to be reacted to. Intuitively, if you have small, slow price movements upwards that create momentum, those actions are not going to create a lot of attention where if you have a biotech that gets some drug approval, clearly you're going to get a massive price reaction and it's going to create "momentum," but it's the type of price action momentum that everyone's already paying attention to. What we identify is that if you look at it, it's kind of drip, drip. Slow, steadier price action versus the crazy price action, that sort of momentum tends to be the one that can predict future performance versus the biotech that went up 100% in a day.

Nate Geraci: Again, we're visiting with Wes Gray, CEO at Alpha Architect and author of the new book, Quantitative Momentum. Wes, you make the point in your book that perhaps momentum investing isn't taken quite as seriously as maybe it should be and you have a very interesting passage describing how fundamental analysts are viewed more credibly because they're pouring over financial statements and conducting rigorous analytical work whereas momentum investors are frowned upon a bit because they're simply looking at price charts or price action, almost like it's some sort of voodoo magic. What do you think it'll take to change this perception?

Wes Gray: Honestly, momentum investing has probably been around since the dawn of cavemen who were trading each other. I'm not sure it's ever going to be taken as seriously as other things that require a lot more discipline and time and grade like fundamental investing. I obviously have great respect for value investing and fundamental investing and I appreciate the elements there and as you guys mentioned I wrote a whole book about it. There's just something about momentum, and there's something about just simple investing in general, like for example, buying Vanguard funds. Even though it's so simple and it's so easy, and we know the evidence is overwhelming that it probably has some sort of benefit, people just don't believe it, and I don't know, it probably goes back to behavior. It is something that, if it's going to work it has to be difficult and complex. There might just be like a human kind of wiring to it to make that association, but in the investment context, that's just usually not the case. Momentum again, it's really not that complex. It works really well and maybe it's just the case that because it's so simple and so easy, people just blow if off as like, that can't be real, but the evidence is pretty clear that it is.

Jason Lank: Wes, while many investors may not be as familiar with momentum investing as they should be, they're probably familiar with the standard Morningstar style box. We've all seen it. In the left-hand column, small, medium, and large cap, and on the upper row you've got growth and value. Is it a mistake to think that well, growth investing, that's momentum, right? Are they the same thing or are there differences?

Wes Gray: There's certainly differences and they're really important to understand. The issue is that the difference is very nuanced, so growth, as traditionally defined in academic research and a lot of those tables is really about the price relative to some fundamental, so you know a PE of 30 would be a growth stock, a PE of 5 would be a value stock, but momentum is independent of a price to some fundamental. Momentum is all about price action only, which means you can have a stock that has really high momentum, but it could have a PE of 30 or a PE of 5. It's really kind of independent of growth and momentum is the factor that actually generates returns, whereas growth, if someone just blindly buys expensive securities, that's actually an underperforming bad bet over time, where if someone just buys high-performing securities, independent of their price ratios, that is a positive expectation bet, at least historically. That nuance where growth is typically a price to some fundamental where momentum is just straight up prices, it actually matters significantly for expected returns and what the evidence actually says.

Jason Lank: Wes, not to pick on Morningstar, they're certainly a wonderful organization, but as I look at the style box, I think to myself, they're already framing my decision making process in terms of small, medium, large, growth, value. They're not even giving me the option of additional momentum information and perhaps that nuance that you just spoke of. Are they doing investors a little bit of a disservice by not including that information?

Wes Gray: Yeah, I think they are, but Morningstar, they obviously do a lot of great service in the sense that they have all the information available and they're trying to help people make better decisions, but they're also a bureaucracy. They've been around a long time, so I can imagine that if they said, "Hey, let's put momentum in there," that would probably, one, the engineers would get mad, the IT guys would get mad, all the fund managers who have been labeled growth and market that are probably going to get angry, so it's one of those things where I think it's just part of the ecosystem now. Even though, from an evidence-based standpoint and from an intellectual standpoint it makes no sense, it's one of those things where it'll probably be around there forever I imagine.

Jason Lank: I guess anybody who's worked for a large corporation understands this corporate inertia and overcoming it, even if everyone knows it's wrong, changing the system is just very difficult. That's what you're really saying.

Wes Gray: Yeah, exactly. It's baked in the cake at this point.

Nate Geraci: Again, we're visiting with Wes Gray, CEO at Alpha Architect and author of the new book, Quantitative Momentum. Wes, right at the top of your book you talk about how it's an individual stock picking book and not an asset allocation or market timing book, but my sense is that many of our listeners are probably unlikely to run a momentum strategy on their own. I think for many investors, if they believe in momentum, they prefer buying a fund that does the heavy lifting for them. I want to talk about some of the considerations in selecting momentum-based funds. According to ETF database, right now, there are over 30 ETFs with some sort of a momentum-based strategy. What do you think are some of the most important factors investors should consider when comparing these ETFs?

Wes Gray: So when looking at momentum-based funds as you mentioned, it's really important to differentiate between is this momentum applied to stock selection or is this momentum applied across asset classes? What I'll speak to is the universe of momentum funds that are doing stock selection. Frankly, there's only a handful of them, like I know of three or four off the top of my head. They're all pretty good offerings because they're in that ETF structure so they can deal with tax problems associated with momentum and I think they're all good offerings, but the two things I'd focus on is process and the fees paid. On the process part, which is arguably the most important, because you always want to know what you're buying and why you're buying it, one of the fundamental kind of evidence-based facts about momentum is that the higher performance is generated via portfolios that hold fewer stocks and have higher turnover, whereas momentum, if you have too many holdings and you don't turn it over fast enough, you don't actually capture the momentum effect, so there are, and one wants to be very careful that when they're buying a momentum ETF, they actually read the methodology file, because if you have an ETF that does "momentum" and it has over 100 holdings and it turns over once a year or twice a year, even though it may be really cheap, it's not doing anything for you. You might as well buy a Vanguard fund. If you're going to buy a momentum fund you want it to have concentrated holdings and you want it to have fairly high frequent turnover because it's going to actually deliver you the momentum premium. Once we understand the process and what this thing is going to deliver in expectation, then we want to understand, well, what are the fees paid for this exposure and are they cheaper relative to all others who are doing something similar, so again, process, know what you're buying, and then fees, know what you're paying for relative to other opportunity funds out there.

Jason Lank: Wes, you mentioned high turnover and high conviction, and high conviction to me implies smaller holdings. Not a 500 stock ETF, but perhaps 50 or around that number. Now, when you get to the size of a holding, does that imply that there's a ceiling to the amount of money that can go into momentum? If everybody were to read the book and order it, and I hope they do, and start applying these techniques, does this get crowded out, or is there a cap anywhere to how much momentum is out there to capture?

Wes Gray: One of the hard truths about the marketplace is there's definitely no free lunch and opportunities don't go on forever and money doesn't grow on trees. With momentum specifically, if you want to capture that premium, as you mentioned you have to do it concentrated, i.e. less than 50 holdings, and you've got to have turnover. Quarterly rebalances at probably a minimum. Of course, what does that generate? That generates a lot of frictional costs, which means that if we try to jam billions and billions of dollars into a fund structure doing a process like that, it's going to quickly arbitrage itself out of existence. That's just a reality, but if you are going to buy a fund that does that, you want to make sure it doesn't have billions of dollars because the total capacity on that is probably maybe two to five billion dollars in the very concentrated form. To the extent that people like myself are building a fund like this and it attracts assets from investors that actually hold onto it, that's a critical piece of arbitrage in this way is you've got to have investors actually stick with it, then over time one would arbitrage high conviction momentum, which is frankly our goal and if we "arbitrage" it away that means our investors would have done pretty well, so that would be a good problem to have and something that we'd like to look back in 20 years from now and say, "Hey, we're the guys that actually arbitraged away value and momentum, because that means we probably did a good service for our investors.

Jason Lank: That'd be a great thing to have on your resume. I want to switch gears for a second and talk about a term you used that was really an ah-ha for me in the book and that's seasonality. Referencing the fact that momentum perhaps on a calendar year basis isn't necessarily smooth and there may be some factors or behavioral factors, tax factors, and other things that may impact that. Talk about that a little bit.

Wes Gray: One of the things we knew from churning all the data on momentum is the turnover piece matters. We know in a vacuum if we did monthly turnover, that'd be better than quarterly, but you also trade three times as much, so we said, "Hey, what if we do quarterly, but we can find a way to rebalance in a strategic way to exploit these seasonality effects?" Probably the most intuitive, well there's two of them that are actually both intuitive. There's tax loss season, i.e. at the end of the year, high momentum names don't have a lot of sellers because no one wants to realize taxes, so when you have a marketplace where there's not a lot of supply and the demand's constant, you can get like a drift effect at year-end, and then same thing on losers, like low-momentum stocks tend to be getting sold even more at the year-end, so you kind of have like an enhanced momentum effect at year end just from taxes. The other one is there's a thing called the window dressing effect. What a lot of institutional managers, especially like mutual fund folks do, is at the year-end they have to post their book, and we do too. Everyone has to post, hey what do you own? If the whole year you've been making bad calls but you've got, now I've got to send this report out to your investors, even though your performance stinks, you may have an incentive to buy high performance names so when investors get their paperwork, they're like, "Oh, well it didn't perform that well, but he owns Amazon, so he can't be that dumb," and it's called window dressing. You're trying to pretty it up. What happens is you create this kind of weird demand effect for high momentum names around quarter ends when mutual fund managers have to post their books to the investor community and so a momentum strategy where it's strategically timed to rebalance in the high momentum names before that happens gives momentum a slight edge where it can try to capture and essentially get ahead of this trading flow that comes from mutual fund managers and others who are trying to make their book look like something it really isn't.

Nate Geraci: Wes, for every investor listening to this show, whether they may be considering a momentum-based fund or selecting individual stocks based on momentum, high level, where does the momentum strategy fit in an investor's portfolio?

Wes Gray: So I'll just tell you how I use it on my personal money, because me and my partners we basically build products for our own capital, and so we have huge value exposures because we have big value investors and Warren Buffet fans. Where momentum fits most strategically is actually as a counterbalance to value just because historically they're kind of like yin and yang, so when value tends to be blowing up, momentum tends to be doing really well and vice versa, so you kind of get the most bang for your buck with momentum when it's set next to a traditional deep value strategy. If you're not a value investor, you're just a generic kind of Vanguard passive index investor, momentum could fit in there in the sense that momentum is going to give you a little more volatility but also a lot more expected return, so if you want to kind of get a piece of your portfolio that's going to give you a little bit of a kick, momentum is something that you could use to pop in there, I'd say.

Nate Geraci: You mentioned the volatility potential with momentum investing. For investors who are in a properly constructed momentum-based fund, just to be clear, what type of ride should they be prepared for? What should the expectation be in terms of risk/reward?

Wes Gray: Again, going back to the original conversation on 'Why doesn't everyone do this?' is momentum is, it's momentum. It's a roller coaster, so hence we know historically the volatility estimates on concentrated momentum portfolios are anywhere from 25 to 50% higher than just buying like an S&P 500 Vanguard fund. I would say if you're going to do momentum, you've got to have discipline and you've got to think five, ten years down the road, because in the short-term it's going to be bouncing all over the place and it's highly volatile, which that's just a reality. If someone's not mentally prepared for that and they're someone who, when they see volatility then they give up, that's actually the worst type of person that should be doing momentum. You really need long money that can take a lot of bouncing around in the short run, and in return you get compensated in expectation, but it may take five to ten years, so just kind of have the right mindset to do momentum.

Nate Geraci: Well Wes, with that we'll have to leave it there. As always, thank you for joining us today. Again, best wishes to you and your family this holiday season. Thank you.

Wes Gray: Yeah, thank you guys for having me and like I said, happy holidays to everyone and have a great Christmas and happy New Year.

Nate Geraci: That was Wes Gray, CEO of Alpha Architect and author of the book Quantitative Momentum. If you have an interest in learning more about momentum investing, I would highly recommend visiting Also, Wes' book is available on Amazon, and I should note that Wes is a great follow on Twitter. His Twitter handle is @AlphaArchitect.