18 Nov, 2021

Keep your friends close and your enemies closer

INSIGHTS Market Insight

It is hard to pick up any current financial publication without a piece debating the continuing Value-Momentum rotation and the impending inflationary environment we face. In this piece we make the case that rather than choosing Momentum or Value, having both as building blocks in a diversified portfolio is prudent.

If an asset’s price goes up, ceteris paribus, it gets more expensive. If it continues to go up (Momentum), ceteris paribus, it continues to get more expensive. Whilst ‘ceteris paribus’ in financial markets is inconceivable, this concept still holds and underpins the antagonistic relationship that Momentum and Value have. The friction in this relationship manifested itself following the vaccine announcements at the end of 2020. The Pfizer & BioNtech announcement on 9th November triggered Value to outperform Momentum by 6.5%, a 10-sigma event and the most extreme daily rotation between the two since records began – even more extreme than when the US Federal Reserve cut rates in October 2008.

How can I reduce my factor rotation risk?

Broadly speaking, Momentum and Value are negatively correlated, with an average correlation of -0.34 making them ‘enemies’ in the conventional sense. Since the financial crisis this relationship has been even more strained with an average correlation of -0.61. Whilst not the only important factor to measure diversification potential, a negative correlation between two assets likely indicates that there are benefits to be had from some combination of the two.

We create an efficient frontier through differing combinations of Momentum and Value (Fig. 1). It shows that an allocation of 40% Momentum and 60% Value would lead to the highest risk-adjusted returns with a Sharpe Ratio of 0.71, greater than both 0.39 for Momentum and 0.27 for Value. This combination would also reduce the maximum drawdown to -41.4% compared with -76.8% for Momentum and -58.7% for Value.

Figure 1: The figure shows the annualized return and volatility of different momentum/value combination strategies, from 1927-01-31to 2021-03-31. The efficient frontier illustrates that a 40/60 momentum/value combination strategy (Point E) provides optimal risk-adjusted returns. Momentum represents the Fama/French momentum factor portfolio and Value represents the Fama/French high-minus-low (HML) factor portfolio. All figures in USD. Source: Arabesque Asset Management

Rather than treating Momentum and Value allocation decisions as discrete, the evidence suggests that combining the two can lead to superior risk-adjusted outcomes for an investor. This phenomenon can also be extended to diversification across asset classes . As the old saying goes, ‘keep your friends close and your enemies closer.’

References

Correlation, Return Gaps and the Benefits of Diversification’ (Statman & Scheid, 2008) 

‘Value and Momentum Everywhere’ (Assness, Moskowitz and Pedersen, 2013)

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