Let’s say that you have reviewed enough of the body of work on momentum to have concluded that momentum is able to generate excess returns over time and that you want to employ it in your investments. Now what—where does it fit in an allocation? As much of the research indicates, momentum is more highly correlated to growth than it is to value. Therefore, you might think of it in terms of a way to diversify your portfolio from value.
Further insight comes from this study published by RBC Capital Markets in 2011 that points out that since the 1930s, momentum has outperformed value, growth, and the S&P 500. Value also outperformed the S&P 500, but growth underperformed them all.
Yet, how many allocations remain diversified between growth and value when they might be better off by replacing their growth exposure with momentum?
For example, consider the growth of two sample portfolios from July 1995 – November 2013. One portfolio is 50% Russell 1000 Growth and 50% Russell 1000 Value. The other portfolio is 50% Momentum and 50% Russell 1000 Value.
Source: Russell Investments, Ken French Data Library: Momentum Portfolio is Top Half Market Cap, Top Third Momentum
Over this period of time, the Growth/Value portfolio had an annualized return of 8.84% while the Momentum/Value Portfolio had an annualized return of 11.25%. It is also noteworthy that the standard deviation was virtually identical for this time frame: 15.85% for the Growth/Value portfolio and 15.84% for the Momentum/Value Portfolio. For comparison, the S&P 500 had an annualized return of 8.72% and standard deviation of 15.61% over this same time frame.
So where does momentum fit in a portfolio? Try replacing your growth exposure with momentum and see if your results don’t improve over time.
Dorsey Wright is the index provider for a suite of Momentum ETFs with PowerShares.
Past performance is no guarantee of future returns. All results above include dividends, but do not include any transaction costs.