Turning on its head the “raging debate” over which investment style is better, value verses momentum, AQR’s Ronen Israel set out to prove that like the Taste Great/Less Filling fight over beer, value and momentum investing perform better together than apart. During the 2016 Morningstar ETF conference in Chicago on Thursday, Israel laid out his argument, breaking down current beliefs into fact and fiction.
“We believe both value and momentum work, and offer good long-term sources of return,” he told the audience.
1) Fiction: Value investing can only be successfully implemented in a concentrated portfolio.
Using Warren Buffet as an example of a value investor, that is, someone who focuses on a group of related companies he knows, Israel thought Buffett was an aberration and perhaps not a pure value investor.
“Just because you find someone who is successful at something doesn’t mean it’s the only way to do it … and it isn’t the only way to capture value,” Israel said, adding, “Maybe diversified value investing can work.”
For example, index funds that are value based provide exposure in a more systematic way.
2) Fact: Value is best measured by a composite of many variables.
In looking at five different metrics, book-to-price, earnings-to-price, cash flow-to-price, dividend-to-price and long-term reversal, it was found it was best to review all the metrics and not focus on one. This is especially true when looking how each metric performed within various decades. Israel concluded: A value investor should define value and implement value using multiple metrics as opposed to relying on one valuation metric.
3) Fiction: Value is a passive strategy because it has low turnover and is rules based.
“Anything that deviates from the market portfolio is active by definition,” Israel said. Those who define value investing as passive are wrong. Using Bill Gates as an example, he said the Microsoft founder sold shares each quarter on a pre-set plan, which isn’t low turnover. He argued Buffet was hardly passive, and in fact was an active manager, thus low turn over doesn’t equate to passive.
And regarding rules based argument: take note of high frequency traders of Michael Lewis’ “Flash Boys” fame, who are extremely rules based but hardly passive investors.
“It’s just semantics,” Israel said. “The key is you are getting a good long term source of returns.”
4) Fact: Momentum can survive trading costs despite higher turn over.
Moving onto momentum, Israel said many old studies doubted momentum strategy could survive in the real world due to trading costs. Israel and others at AQR decided to review this and used a trillion dollars worth of live data going back to 1998. They looked at trading costs of both value and momentum strategies, and found previous studies had estimated trading costs far higher than they actually were. They also found there are ways to optimize around trading costs, building portfolios that are transaction cost aware, and not suffering style drift.
5) Fact: Momentum is more tax efficient than often touted.
Israel pointed out a hidden truth: turnover doesn’t translate to hidden taxes. In the case of momentum, there is “good” turnover generating long-term gains and short-term losses. “It’s the characteristic of the turnover, the nature of it,” he said. He added there were ways to optimize around this as well without any degradation or style drift, but by pulling off the trade at the right time.
6) Fiction: Momentum is too volatile and sporadic to be essential to a portfolio.
There was “little empirical evidence” to support these claims, Israel said. Momentum has a high sharp ratio, which shows the consistency of the strategy, he said.
7) Value and momentum investing are applicable to far more than just choosing what stocks to own or avoid.
Israel showed results of using both strategies with various asset classes, including bonds, real estate, currencies and commodities, and most led to positive returns.
8) Fact: Value and momentum often work best together.
Israel showed how because they are negatively correlated, they perform well at different times. For example, during the tech bubble bust from 1997-2000, value took a dive while momentum held its own. Then in Spring 2009, momentum was tripped up but value had a positive time. He noted that incorporating momentum may help value investors avoid companies “that are cheap for a reason. It cleans up a value strategy.” He also pointed to the combo of the two styles performing better together than separately over the long term.
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