Last week, we saw that a momentum strategy could theoretically reduce tracking error in small- and value-tilted portfolios. Today, we’ll see if this has made a difference historically.
Last week's post referenced the potential improvement that an allocation to a momentum-based stock strategy can have in terms of reducing the tracking error in small- and value-tilted portfolios. Keep in mind that momentum is the tendency for stocks that have done well in the past to continue doing well in the near term and vice versa.
One of the interesting features of momentum is that it tends to do well when small and value stocks don’t. So adding momentum to a size- and value-tilted portfolio has the potential to reduce tracking error. Using index data from AQR Capital Management, we can test this historically, with the important caveat that these are on-paper results and don’t reflect transactions costs or fees.
For the period of 1980–2011 (1980 being the first year that AQR has compiled data for its momentum indexes), I compared the tracking error of the size- and value-tilted portfolio in last week’s post* to a portfolio that allocates 80 percent of its assets to that same portfolio and 20 percent to a diversified long-only momentum strategy using AQR’s index data.**
The annual tracking error of the size and value-tilted portfolio without momentum has been about 9.6 percent per year, which indicates there’s potential for substantial underperformance and outperformance in any single year. For the portfolio that includes momentum, tracking error is reduced to 8.1 percent. This is a substantial improvement in tracking error. Note that even though this helps, you still can’t dramatically reduce tracking error without markedly reducing size and value tilts.
So what are some of the other factors to consider before adding momentum to your portfolio? First and foremost, there are no good risk-based explanations for why momentum exists. This is an important consideration, since this makes one wonder whether it will continue. Nevertheless, momentum has been extremely robust across time and asset classes and after it was discovered in the early 1990s. Second, momentum-based strategies are more trading intensive and not particularly tax efficient, so some return will undoubtedly be lost to these costs. This shouldn’t, though, have a big impact on the tracking error benefits.
Random Links and Commentary of the Week
Nothing much this week other than sharing a few songs that I’ve been enjoying:
* Portfolio composition: Dimensional Adjusted Market 2 Index: 26.5%, Dimensional US Large Cap Value Index: 8.5%, Dimensional US Small Cap Value Index: 25%, Fama/French International Value Index: 13.584%, Dimensional International Small Value Index: 12.51%, MSCI EAFE Index: 2.17%, Dimensional International Small Index: 1.736%, MSCI Emerging Markets Index: 5%, Fama/French Emerging Markets Value: 2.5%, Fama/French Emerging Markets Small: 2.5%.
** Portfolio composition: (1980–1989) AQR Large-Cap Momentum Index: 50%, AQR Small-Cap Momentum Index: 50%; (1990–2011) AQR Large-Cap Momentum Index: 30%, AQR Small-Cap Momentum Index: 30%, AQR International Momentum Index: 40%.