Larry Swedroe’s “Look at Value, Quality, and Momentum” article in IndexUniverse is a must-read for anyone looking to understand the benefits of factor-based investing.
One reason that combining the strategies adds value is correlation.
Specifically, signals in gross profits-to-assets and momentum are both negatively correlated with valuation ratios, and profitability and momentum have low correlation. Thus, they hold very different stocks.
Swedroe cites a study by Robert Novy-Marx covering the period 1963-2011 that looked at the results of building a portfolio consisting of a combination of value, profitability, and momentum:
Marx then looked at combining the value and profitability strategies with momentum in a single portfolio. Over the same July 1963-December 2011 period, he found that a dollar invested in the market would have grown to more than $80; a dollar invested in large-cap winners (momentum stocks) would have grown to $597; a dollar invested in cheap large-cap winners would have grown to $411; a dollar invested in profitable, cheap large-cap stocks would have grown to $572 dollars; and a dollar invested in profitable, cheap, large-cap winners would have grown to $955.
Given that trading costs are relatively low in large-caps, even if turnover for a combined strategy was fairly high, the strategy seems to hold great appeal given the size of the premium.
Citing a different paper by AQR Capital also on the topic of combining value, quality, and momentum, Swedroe stated the following:
Another benefit of the core approach is more consistent performance. AQR’s study, which covered the period since 1980 in the U.S. and since 1990 in international markets, found that a simple value portfolio experiences significant five-year periods of underperformance, while the core portfolio effectively eliminates any such episodes, outperforming the market in every five-year period historically.
The key here is that combining different winning return factors—including value, quality, and momentum—has historically greatly benefited an investor both from a cumulative performance perspective and also from a performance consistency perspective. Both cumulative performance and performance consistency are critically important to a client.
Past performance is no guarantee of future results.