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Is The Acceleration Factor A Better Way To Measure Momentum?

Momentum has received a lot of attention in the asset-pricing literature over the past several decades, and for good reason. Trending behavior is a staple in markets. In contrast with other pricing “anomalies,” short-term return persistence – positive and negative – is a robust factor across asset classes. The fact that momentum is deployed far and wide in the money management industry and hasn’t been arbitraged away suggests that the persistence factor is persistent. The question is whether momentum as traditionally defined can be enhanced? Yes, according to a small but growing corner of research that looks at price trends through an “acceleration” lens. Momentum is generally defined as the directional bias for asset returns to persist, particularly over a 6- to 12-month period. The modern age of momentum research begins with Jegadeesh and Titman’s 1993 study “Returns to Buying Winners and Selling Losers: Implications for Stock Market Efficiency.” Fast forward to the present and you’ll find a small library of research that extends the analysis in a variety of directions, including the recent focus on the so-called acceleration factor. There are several ways to define acceleration, but the general concept is simply a methodology for measuring changes in momentum – “the first difference of successive returns,” as a recent paper explained ( “The Acceleration Effect and Gamma Factor in Asset Pricing” ). What’s the value of monitoring and measuring acceleration? This study finds that it provides “better performance and higher explanatory power than momentum.” As such, “momentum can be considered an imperfect proxy for acceleration.” That’s an intriguing comment since momentum is already viewed as a solid framework as a risk factor and as the raw material for profitable trading strategies. But can we squeeze even more from this realm of asset-pricing analytics in the search for robust signals? Perhaps. Another line of research along these lines comes to us by way of Morningstar, which recently published an academic study that found that acceleration is quite useful for anticipating severe market losses. ” The Economic Value of Forecasting Left-Tail Risk ” reports that the geometric return for the most recent six-month period less its equivalent over the preceding six months, along with trailing 1-year return, are powerful factors for predicting negative skewness in returns. The results suggest, according to the authors, “that it is possible to reduce tail risk without giving up returns.” There are a number of variations one could devise in trying to mine acceleration as a risk metric. David Varadi has explored several possibilities, including what he labels the volatility of acceleration (VOA). Noting that this indicator has interesting properties for estimating volatility and adjusting asset weights, he writes that “the VOA framework is one step in the direction of looking at alternative and possibly better measures of volatility.” The research on acceleration and its applications is still in its infancy, but the early efforts certainly look intriguing. It’s premature to abandon momentum in favor of acceleration. But there’s a compelling case for expanding the definition of price persistence.

How Long Can You Stick With Failing Factor Investing?

Someone asked me the other day why I reject factor investing. My answer was simple. I said that factor investing is usually just a good marketing pitch to charge higher fees for something that will give you most of the correlation of a market cap weighted portfolio. For the uninitiated, factor investing is one of the hot buzz words in portfolio construction these days. Researchers found that “risk” doesn’t properly describe what drives returns over the long-term and several other factors were discovered that explain some of these outperforming anomalies. For instance, value stocks tend to outperform and momentum stocks often outperform. But this isn’t always the case. This is simply the case inside of the rather small data set that researchers have mined so far. And that brings us to a rather gigantic problem with factor investing: these factors can go through extremely long periods of underperformance. Eddy Elfenbein does the legwork over at Crossing Wall Street where he shows that value has underperformed the S&P 500 for 8 years. That’s an entire market cycle! I’m not sure there’s a single investor who would put up with that type of underperformance. And yet factor investing is more popular than ever. In fact, we keep coming up with new factors by the day. And when one fails we move on to some other fancier and more intricate sounding sales pitch. But here’s the really big problem for me. When you buy stocks you shouldn’t look for the absolute best portfolio. There are no holy grails. You are just looking for an adequate portfolio that reflects a very broadly diversified set of equity instruments. You don’t need the best return. You want most of the return. But most factor portfolios just increase tax and fee frictions while giving you a substantial amount of the equity correlation that you’re looking for in a portfolio. But what we find with all of these factor funds is that they’re still very highly correlated with their benchmark. If you can decide when that correlation shifts a tiny bit to give you some slice of outperformance then you’re much smarter than me and everyone else in this business. Here’s a simple example of what I mean here. If we look at growth relative to the market cap weighted portfolio we find that the two portfolios have a 96% correlation over the last 15 years: In the early 2000’s growth looked terrible relative to market cap weighting. And then it has dramatically outperformed since the financial crisis. But over the course of the entire cycle there’s no telling where you would have gotten on and off that roller coaster ride. All we know is that you got 96% of the equity market correlation. And if you jumped on the growth roller coaster you paid a higher fee and you MAYBE outperformed. So, when you start looking for that holy grail in the factor pool you really start doing two things that are cardinal sins in the world of indexing: You’re relying on being able to time when a factor will or won’t outperform. You’re increasing your fees in the pursuit of beating the market. Breaking those rules just don’t make a lot of sense to me. I prefer to keep things simple. So, maybe I am too hard on the factor investing crowd, but I just don’t see why we should pay extra for something that might give you better performance, will definitely give you most of the correlation and will definitely increase your fees. Share this article with a colleague

With Further Market Declines Likely, Keep The Long Run In Mind

This article originally appeared on the Independent Observer Blog . August was the worst month for U.S. markets in more than three years, so say the headlines. I suspect it was also the worst month in at least that long for many international markets as well. And, as today’s numbers show us, we aren’t done yet. As I write this, U.S. markets are down about 2.5 percent, and European markets closed down around 3 percent. There is actually not much more I can add to what I’ve already written. Current valuations remain relatively high , and there is certainly the potential for further declines if the market adjusts to more typical valuation levels. From a correction standpoint, the S&P 500 is still down less than 10 percent from the peak. In other words, for all the hype and worry, we are in a market decline that, by historical standards, is both small and normal. This is not to minimize the current situation, however. Substantial technical damage has been done to U.S. markets, which remain below both the 200-day and 400-day moving averages. This suggests to me that more weakness is very likely. Indeed, the odds of a more substantial decline are, in my opinion, rising as confidence continues to erode. Many decision rules that have tested well in the past are now pointing to more declines as well. With further market declines likely, what should you do? If you have longer-term money invested (i.e., you don’t need it for 10 years or more), try to stay put. And if you’re still contributing to your portfolio, remember that the decline actually represents an opportunity, since you can invest at lower prices and benefit from potential future growth. If you have shorter-term money invested (i.e., you need it in the next couple of years), or if you’re already drawing down your portfolio in retirement, work with your financial advisor to determine what effect a large decline would have on your financial well-being. Hopefully, your portfolio is structured in a way that any decline will have minimal impact over time. If not, you might want to consider making changes to ensure that is the case. Once your portfolio design meets your needs, though, unfortunately, there is little left to do but buckle up and endure the ride. Why this decline looks different I won’t say enjoy the ride, of course, but to make it less painful, consider that this decline is different: First, many previous and major, long-lasting declines – 2000 and 2008 being the most recent – came at the end of multiyear debt-fueled booms. We might get to that point eventually, but we’re not there now. Households have actually continued to pay off debt during the past few years, not add to it. Second, sustained declines typically took hold during periods of recession while, today, the U.S. economy continues to grow in a sustainable way. Third, the lack of corrections like this over the past few years has, arguably, been unhealthy. The current decline is actually a painful but necessary step to clear out market excesses and lay the groundwork for further advances. This prescription – prepare and keep the long run in mind – is neither easy nor satisfying. The only real thing it has going for it is that, over time, it generally works. That is what I try to focus on, and I suggest you do the same.