From Pragmatic Capitalism, Jan. 23:
When you’re choosing an equity market allocation I generally prefer to keep things simple – just buy a low fee global market cap weighted portfolio and call it a day. If you build your hedges (bonds or whatever) around that slice correctly then your asset allocation will match your risk profile and you’ll have a reasonably good probability of having constructed a plan that you’ll stick with and will work just fine for you over long periods of time.
One of the reasons why I like a market cap weighted stock allocation is because it’s a momentum strategy. Now, don’t get me wrong. I’ve been pretty clear that I don’t love factor investing. But momentum works for a fundamental reason – it’s the natural evolution of creative destruction. You could say that all market cap weighted index funds are momentum funds because they more or less reflect the process by which corporations succeed and fail.
The S&P 500, for example, is a momentum strategy. It’s a simple low fee market cap weighted momentum strategy. The reason most more active managers can’t beat it is because they are less tax and fee efficient and don’t benefit from the economies of scale that the S&P 500 index does. But the kicker here is that if you look under the hood the S&P 500 is just a big momentum strategy that systematically sells losers and buys winners. It does this by creating a rules based system for inclusion in the index. When a company doesn’t meet that standard the index committee chooses to sell it and replace it with a company that meets their criteria.
The primary reason why this works so well is because it is a systematic way of aligning yourself with the success of corporate America over time. Corporate America, after all, is a big momentum machine that systematically kicks out inefficient entities so that newer more efficient entities can take their place. As consumers we tend to spend a little bit more money each year in a systematic manner and that growing monetary pool gets spent across an ever changing group of companies who compete for that money. This shows up in corporate profits in what looks like a big stream of profits with ever increasing momentum.
If you look at a chart of corporate profits you can basically see what the S&P 500 is doing – it’s systematically attaching itself to the stream of corporate profits over time because it’s removing failing firms and replacing them with firms that are capturing that market share.
I guess we’re all momentum investors. Although I’d argue that some are smarter than others. Market cap indexing just so happens to be a very low fee and tax efficient form of momentum investing.......MORE
HT: Alpha Ideas Linkfest, Jan. 24
Previously, in no particular order:
It's Anomalous: "Fact, Fiction and Momentum Investing"
AQR's Cliff Asness: "Fact, Fiction and Momentum Investing"
Momentum As The Only Reliable Market Anomaly
Market Anomalies: When Momentum Crashes
Anomalies: Can Momentum Be Arbitraged Away?
Market Anomalies: Can You Combine Value and Momentum?
Whoa! Has The Small-Cap Premium Disappeared? That Would Leave Only Momentum in the Tried-and-True Anomaly File!
Rob Arnott's Research Affiliates: "Finding Smart Beta in the Factor Zoo"
Factor Investing: Factors Hated and Loved
Questions America Wants Answered: "What Is Idiosyncratic Alpha?"
New York Fed: "Can Investors Use Momentum to Beat the U.S. Treasury Market?"
And many more, use the 'Search blog' box if interested.
