Zen and the art of going with the momentum

In this week's article I want to be deliberately daring, almost provocative! Why not be very, very bullish about equities by going long on risky, momentum-driven stocks for the long term?

Now let me say right from the get-go that personally I'm only cautiously bullish about equities at the moment. I can't help but think we're due a good thrashing in equities, with maybe a 5%, or even 10%, (downward) bump.

Yet I also see no reason to think that equities aren't likely to be the best asset class over the next few decades, which is, of course, the sensible timescale for stock market investing.

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Obviously you could ignore this view and take note of the constant noise of markets. Bill McQuaker, co-head of multi-asset at Henderson Global Investors, put out a lovely short note this week that crystallised all the fears, worries and anxieties swirling around the markets quantitative easing (QE), mounting debt, valuation multiples looking stretched.

As a MoneyWeek reader, I'm sure you won't need much more detail about these concerns, but McQuaker also reminds us that there's lots of good news out there. My guess is that all this noise is irrelevant if you are focused on the next 20 years.

In this alternative universe of zen-like investing where, by the way, your essential reading must be William Bernstein's latest book, Rational Expectations what you really needto be is double long' on equities.

I've already explained the first long' in equities. That's the fact that equitieswill probably (but not definitely) provide some extra return for taking a high level of risk. None of us know how much this equity risk premium will be in real terms, but my guess is probably around 3% to 4.5% per annum on average over the next few decades.

My second long' is to say that if you think equities will do well, go the whole hog and double down on risk. Gear up those returns from equities by favouring those types of equities most likely to outperform.

What this means is that our zen-like investor will probably be on a roller-coaster ride, investing in the most successful equities out there with the highest volatility. Why? Because of what I call the dirty secret of modern investment research: momentum works.

Study after study has revealed that when it comes to selecting a stock, it's better to pick those with the greatest positive momentum behind them. In other words, you should focus on shares that have gone up by the most relative to the wider market over the last one to 12 months.

The existence of momentum is a well-established empirical fact. Jegadeesh and Titman published one of the first influential studies on momentum in 1993, Returns to Buying Winners and Selling Losers: Implications for Stock Market Efficiency. They found that US stocks with the best performance over the past three to 12 months continued to outperform the worst-performing stocks over the next year, using data from 1965 to 1989.

Looking at a wider research set of data and analysis, Cliff Asness and colleagues from investment firm AQR discovered that the momentum-risk premium is "evident in 212 years [yes, this is not a typo, 212 years of data from 1801 to 2012] of US equity data, dating back to the Victorian age in UK equity data, and in over 20 years of out-of-sample evidence from its original discovery, in 40 other countries, and in more than a dozen other asset classes".

Yet despite these widely accepted numbers, very few investors actually use funds that are explicitly momentum-driven. Many professional investors worry that momentum has practical flaws. US-based Ryan Larson of Research Affiliates nicely summed up the concerns in a paper from August 2013 called Hot Potato: Momentum As An Investment Strategy.

Larson accepts that momentum appears to work as a strategy, but he also reminds investors that momentum, like its peers, such as value investing, is "time-varying" a jargon-filled way of saying that buying momentum stocks only works some of the time. And the bad news is that in recent years momentum has not worked.

However, that may change over the next few years momentum has always ebbed and flowed depending on what's happening in markets. Larson also raises another common concern that momentum strategies involve extensive trading and excessive volatility. One factor putting off many fund managers is the excessive trading in smaller liquid stocks that comes with momentum investing.

But a recent paper from this summer by hedge-fund manager Cliff Asness nails all of these worries. If you are interested in the more pointy-head world of investing, I'd suggest this paper is absolutely worth tracking down it's called Fact, Fiction and Momentum Investing.Just google the title and author, and you'll easily find the paper on the web.It's a brilliant read and Asness and his teams demolish every single one of these criticisms yes, momentum can underperform for some years, as you'd expect.

No, there isn't too much focus on small caps and no there needn't be excessive volatility when it comes to operating the strategy.

Given the huge amount of money AQR runs and Asness' record as a pioneer of quant' investing strategies at Goldman Sachs, I think it's worth paying attention to what he says. (Quant investing is when investors use massive computing power to find predictable patterns in financial data.)

And Asness isn't the only analyst and investor who says that momentum works. Of the long list of momentum fans, I'd focus on Mebane Faber at Cambria Investment Management. Back in 2010 he wrote a paper called Relative Strength Strategies for Investing, which outlinesa number of very simple methods"that an everyday investor can use to implement momentum models intrading.

The focus is on the practitioner with real-world applicability." He looksat a mere 85 years of data (!) andsuggests investors rank every monththe ten sectors in a major index, such as the FTSE 100 or S&P 500, based on trailing total return, including dividends. Faber then applies a number of rules to his portfolio construction:

Buy rule: the system invests in thetop X sectors. For the Top 1 portfolio,the system is 100% invested in thetop ranked sector. For Top 2, thesystem is 50% invested in each of thetop two sectors. For Top 3, the system is 33% invested in each of the topthree sectors.

Sell rule: since the system is a simple ranking, the top X sectors are held and if a sector falls out of the top X sectors, it is sold at the monthly rebalance and replaced with the sector in the top X.

According to Faber, the results are impressive with his relative strength system working in all combinationsof one, three, six, nine and 12-monthtime periods.

Now, you could do all of this yourself simply by moving in and out of sectors both in the US and the UK using sector-based exchange-traded funds (ETFs). In America there's lots of these sector ETFs, while in the UK you're probably best going with broad European sector ETFs based on the Stoxx 600 index.

And your timing signals? Personally, I think Investors Intelligence's superb ETF Global Opportunities email newsletter service does a great job. Although it's a bit pricey at £35 a month, it does give you great technical, momentum-driven signals.

The other alternative is to use a software-based system such as ShareScope, set up the screens that look for relative strength, and then buy and sell the ETFs for each sector based on your own research. It's as simple as that really!

For the lazy among you, there are no UK-based funds or ETFs that do the job, but if you want core US equity exposure, there are some New York-listed ETFs that are easy to buy. These passive funds use quantitative-driven screens to work out what to buy and then include them in the index.

I use the PowerShares DWA Momentum Portfolio (Nasdaq: PDP), which uses relative strength measures to buy individual stocks. The research firm behind this index also offers an alternative fund that buys the strongest relative strength sector ETFs.

This fund is called the First Trust Dorsey Wright Focus 5 ETF (Nasdaq: FV). Another option is the iShares MSCI USA Momentum Factor ETF (Nasdaq: MTUM), which does a similar job at lower cost.

In my view, if you want to invest in US equities over the long term, your best bet is to ignore active fund managers as well as traditional passive ETFs. Instead, you should buy in to a momentum-driven tracker that focuses only on those shares in the S&P 500 with the strongest relative strength.

And I'd add one last twist, preferred by Asness and Co when you build your US exposure, go 50/50 between momentum and a value or fundamental US equity tracker from the likes of RAFI or Dimensional.

There aren't any UK-based equity momentum ETFs, but Lyxor does offer a commodity tracker, the Lyxor ETF Broad Commodities Momentum (LSE: MOMG) that does the same trick for individual commodity markets the good news is that momentum seems to be even more powerful in specialist commodity markets.