“Momentum investing is without redeeming social merit” wrote John Authers almost exactly two years ago in this Financial Times column. “Invest on the basis of value,” he continued, “and you are helping to correct a mispricing. Invest on the basis of momentum, however, and you are deliberately helping a market inefficiency grow even worse.”
Not that his words will have bothered momentum investors too much as they enjoyed a terrific 2015 – in stark contrast, though it pains us to admit it, here on The Value Perspective, to everyone in the value camp. Still, momentum investors’ success raises an interesting question – just who has been enabling them to take profits by buying their overvalued assets? Not true value investors – that much is certain.
One set of possible suspects has been suggested by Dimitri Vayanos and Paul Woolley of the London School of Economics. Their new paper, Curse of the benchmarks, points the finger at fund managers whose portfolios are constructed around a particular stockmarket index. So why are we so certain that excludes value investors? Well, the key word towards the end of the previous paragraph is ‘true’.
For the record, true value investors do not believe benchmark indices are without merit – benchmarks are, for example, just the ticket if you need something against which to measure long-term investment performance. They are, we would however argue, a good deal less useful in the context of risk – and certainly not something investors should look to build a portfolio around.
One reason for this, as we shall shortly see, is because a fund manager who has to ensure their portfolio sticks close to a stockmarket index will in all likelihood end up being forced to play the momentum game. Among other things, this makes the idea of a value manager with tight benchmark constraints something of an oxymoron.
According to Vayanos and Woolley, momentum investing and benchmarking share “the defining feature” of being influenced by fund flows rather than cash flows. “For momentum investors, the motive is short-term gain,” they say. “For benchmarkers it is avoidance of short-term underperformance against the benchmark.”
The danger with benchmarking, the pair suggest, is that in order to comply with their tracking constraints, a manager must control how far the composition of the portfolio departs from that of the index and must be “most vigilant of underweight positions in securities with large weights in the index, especially those with volatile and rising prices.
“If a security doubles in price and the investor is half-weight, the mismatch doubles; if he is double-weighted and the price halves, the mismatch halves also. Underweight positions in large, risky securities therefore have the greatest potential to cause the manager grief.” The effect is most marked when an industry sector or entire asset class is involved – for example, the tech boom of 1999/2000.
In essence, managers who start off underweight stocks with rising prices will find they need to make additional purchases to satisfy their tracking constraints and this, argue Vayanos and Woolley, “describes the plight of value managers forced to buy bubble stocks they know to be over-priced.” Or, as we would put it, “the plight of ‘value’ managers”.
Markets being cyclical beasts, sooner or later, momentum enters the pricing system. When it does, unconstrained investors have a choice. “They can follow fund flows and pursue momentum strategies, hoping to sell before reversal sets in,” as Vayanos and Woolley put it. “Alternatively they can take advantage of mispricing created by over-shooting and adopt value strategies.”
Momentum, they therefore suggest, is “a short-term approach because trends are typically short-lived and pay-offs established quickly”, whereas “value calls for patience while waiting for prices to revert to fair value”. Of course, managers constrained by a benchmark index will not have a choice and will end up pursuing quasi-momentum strategies – and so allow real momentum strategies to cash in.
Vayanos and Woolley conclude that “the buyers of momentum investors’ cast-offs are likely to be value managers complying with the constraints of index benchmarks and tight tracking”. Here on The Value Perspective, we take no issue with the idea that constrained managers could well be the culprits – we just do not believe anyone so constrained can truly be called a value manager.