As market illiquidity usually coincides with poor market performance, momentum strategies have the potential to perform particularly well compared to risk asset in times of crisis.
LTCM – lesson learned
For example, looking before and after the collapse of the Long-Term Capital Management (LTCM) hedge fund in 1998 – a significant period of funding illiquidity and market turmoil – momentum strategy returns were proven to be positive on average in the least liquid months, periods when market performance is likely to have suffered particularly badly.
On the other hand, high liquidity, which usually coincides with large capital flows into the market and sharp price rises, is generally bad for momentum strategies. This is because momentum investors can be left on the sidelines if the rebound follows a period of poor performance, as is often the case.
This analysis suggests that momentum strategies have the potential to be strong diversifiers in times of crisis.
What is also interesting is that the LTCM crisis in 1998 marked somewhat of a watershed, with the correlation with illiquidity becoming even more negative. This might reflect increased investor awareness of the importance of liquidity, which in itself may have reinforced the momentum/liquidity relationship, as investor behaviour become even more sensitive to rises and falls in liquidity (certainly the 2000s saw the emergence of a large number of hedge funds looking to take advantage of this relationship, often using momentum type strategies).
This also suggests, somewhat ironically, that the recent liquidity crisis in 2008 may go even further to reinforce market volatility (and trending), despite a heightened awareness of financial risk.
When do momentum strategies underperform?
A momentum strategy will underperform a buy-and-hold strategy when a market reverses direction very quickly as the momentum investor will be out of the market for the early portion of the rally. This was the case in 2009 when markets stepped back from the abyss and confidence returned very quickly. The liquidity of the strategy at these turning points is an important consideration as momentum investors need to be able to act quickly when markets begin to reverse.
For this reason derivatives usually play an important role in momentum strategies. Interestingly, equity markets also tend to exhibit short-term reversal, where last month’s winners are often this month’s losers. For this reason momentum strategies often omit the most recent month’s data.
Markets also often exhibit longer-term reversal patterns (boom and bust), so investors should be wary of jumping on the band wagon too late.
Finally, momentum strategies will underperform if trading costs are too high. This is particularly the case in markets with only weak trending patterns. Using momentum strategies with longer data windows to restricting trading frequency can help to mitigate this, as can trading in instruments with lower dealing costs (again often using derivatives to adjust positions).
Momentum has the potential to add value across a wide range of asset classes. This can be a standalone strategy or as one input into a wider multi-asset strategy. For example, asset allocations can be tilted to include higher weights in those assets displaying strong positive price momentum. Momentum might sit alongside other ‘conditioners’ on the asset allocation such as the economic outlook and value.
Momentum’s negative correlation with liquidity (and therefore often market performance) means that the momentum element of a multi-asset strategy can act as a strong diversifier, particularly in times of crises. This should reduce the overall risk of a portfolio.
Furthermore, momentum has historically shown a strong negative correlation with more pro-cyclical conditioners such as value.
Momentum can also act as a powerful ‘risk-off’ indicator, perhaps alongside other downside risk indicators, or even as a signal that it is time to put in place specific downside protection measures such as put options.
Conclusion
- Momentum strategies have the potential to enhance risk-adjusted returns across a wide range of asset classes.
- Momentum strategy performance is also negatively correlated with illiquidity and, as such, can be a valuable diversifier in times of market crisis.
- Investors potentially face a decade of weak growth and volatile risk asset performance. In this environment momentum strategies have the potential to add significant value either as standalone strategies, part of a multi-asset portfolio construction process or as part of a wider risk management strategy.
