A Blended Investment Strategy for All Markets: Tobias Moskowitz
In the current economic and financial climate, investors seem to be struggling to find a new strategy that can yield consistent positive returns.
Yet, before seeking something new, there are two proven long-term approaches that investors might want to consider: value and momentum. What’s more, when combined, these strategies produce an even more potent investment vehicle and can be applied much more broadly across asset classes.
The basic idea of value investing is to buy assets that are “cheap” -- meaning that the market value or price is low relative to fundamental or intrinsic value -- and sell those that are expensive. Simple measures of price-earnings ratios or price-to-book values seem to adequately capture this notion and have produced consistently positive returns, on average, for more than 80 years.
Similarly impressive are the average returns over the same period when one looks at data generated by momentum investing, which means buying stocks that have risen in price over the preceding six to 12 months, and selling those that have fallen.
The two strategies seem at odds with each other. While value investing buys cheap stocks and sells expensive ones, momentum strategies seem to do the opposite. How can they both generate positive returns on average?
The answer is that they work at different frequencies. Value investing identifies cheap or expensive stocks such as those whose prices have been falling or rising for several years, while momentum investing entails buying the securities that are becoming expensive and selling those that are becoming cheap, before they actually become expensive or cheap.
Buying winners and selling losers over the past year tends to pick up this momentum effect, but beyond a year or two these stocks start to reverse as the value effect kicks in.
Hence, the two strategies are related. Typically, when one works, the other doesn’t. The technology boom of the mid-to-late 1990s provides an example. Value investing produced very poor returns during this period as hot tech stocks that seemed expensive became more expensive. A momentum strategy produced big returns during this time.
Five years later, when the tech stocks crashed, it was value investing that generated big gains, and momentum that lost. But, here’s the best part: Both approaches produce large positive returns on average, and since they tend to move in opposite directions, especially during extreme market conditions, a combination of value and momentum is a long-term successful strategy that doesn’t often suffer big losses.
What’s more, the simple intuition behind these two methods can be applied more broadly. Although value and momentum are two of the most studied capital-market phenomena, the focus has primarily been on U.S. equities. However, applying the same basic investment philosophy to equity markets internationally, and in other asset classes, produces remarkably consistent returns. In a recent paper, Clifford Asness, Lasse Pedersen and I showed that applying value (using long-term five-year return performance of the asset class) and momentum (using performance over the past year) to assets as diverse as government bonds, equity index futures, commodities and currencies produces strikingly similar results to those for individual stocks. Both value and momentum create positive returns in each asset class and are consistently negatively correlated with each other.
The success of value and momentum in such different asset classes also makes the possibility appear remote that these strategies are due to chance from data dredging.
In addition, and perhaps most interestingly, value returns in one asset class tend to move with those in a different one, and the same holds for momentum. The co-movement across asset classes is much stronger for value and momentum strategies in these asset classes than it is for the asset classes themselves. For example, when value or momentum is in favor U.S. equities, it also tends to do well for currencies, government bonds and commodities, even though, in general, U.S. equities aren’t that correlated with a basket of currencies or commodities.
Value and momentum also tend to move in opposite directions across asset classes. So, when momentum is doing well in U.S. stocks, value will be doing poorly not only in U.S. stocks but also in other markets and other asset classes.
Taken together, value and momentum provide long-term positive returns and offset much investment risk, even more so when applied across markets and asset classes simultaneously. Over the last four decades in U.S. equities, a combination of value and momentum has outperformed the market by 3 percent to 4 percent a year. When value and momentum are applied internationally across equity markets, that outperformance grows to about 5 percent a year, and when applied across other asset classes as well, the strategy has outperformed the U.S. stock market by 9 percent a year on average over the past 40 years.
While the performance of any approach in any given year is never certain, the long-term performance of a combination of these two known investment styles has been consistent.
With new evidence showing the same phenomena exist in many other asset classes, investors would be wise to examine these traditional investment styles more broadly rather than to seek out something new, untested and unproven.
(Tobias J. Moskowitz is Fama Family professor of finance at the University of Chicago Booth School of Business, and is a contributor to Business Class. He also serves as a consultant to AQR Capital Management LLC, which invests, among other things, in value and momentum strategies. The opinions expressed are his own.)
To contact the writer of this column: Tobias J. Moskowitz at email@example.com
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