The funds in question are iShares MSCI Europe Value Factor (IEFV) and iShares MSCI Europe Momentum Factor (IEFM). Like pretty much all ETFs, these two are based on an index; in this instance, the MSCI Europe index, which tracks $8.2 trillion-worth (£5.4 trillion) of the great and the good of European equities. More specifically, the funds track derivative indices of MSCI Europe that focus on 'value' and 'momentum' within the index's 440 stocks.
As such, they permit investors to put into practice - cheaply and easily - an investment plan that comes with the approval of much academic research: combining momentum and value within a portfolio to smooth its returns without reducing them.
Value and momentum are poles apart. Value is all about stocks that are unappreciated and therefore undervalued. Momentum - as its name implies - is all about what's hot. However, in portfolio management - or, at least, the theory - 'poles apart' is good. Whatever are poles apart will dance to different tunes, respond to different factors. They will be yin and yang - when one is stalling, the other will be motoring and vice versa. Yet assuming that value and momentum generate similar long-term returns and that their changes will tend to move in opposite directions, then combining them in a portfolio will reduce the volatility of the portfolio's value while sustaining its long-term performance.
One problem is that it is debatable whether value and momentum do produce similar long-term returns. The popular view may be that, in the long run, value trumps everything - growth, recovery, the lot - and, therefore, must beat momentum. The popular view also holds that momentum is fickle - here today, gone tomorrow. It may exist, but can't be relied upon. Besides, it works better for short-selling strategies - betting that prices will fall - because prices tend to drop quickly and directly, but rise in a higgledy-piggledy fashion.
Popular views can be wrong. Last year, a paper for the Journal of Portfolio Management - Fact, Fiction and Momentum Investing - said that momentum investing has "an impressive long-term average return that survives all the attacks hurled against it"; that its "presence and robustness are remarkably stable"; that "there is little evidence that (it) has weakened since it became well known"; and that there is "little evidence that momentum is related to size; it is almost as strong for large-caps as it is among small-caps".
Specifically, the paper's authors - from AQR, a US hedge fund manager - take extensive data on US equities and find that the average annual return for momentum stocks for the 86 years 1927-2013 was 8.3 per cent. Over the same period, value stocks averaged 4.7 per cent. More recently, in the 22 years to 2013, momentum averaged 6.3 per cent to value's 3.6 per cent. Nor does it seem that momentum's extra returns are a trade-off for extra volatility. In both those periods, momentum's reward-to-volatility ratio (the so-called 'Sharpe ratio') was higher - ie, better - than value's.
Yet, also last year, managers from another US firm, Gerstein Fisher, produced a paper - Combining Value and Momentum - which found that, largely because of higher dealing costs, momentum portfolios did worse than value portfolios and sometimes failed to beat the market. However, and significantly for ETFs, the fund manager also found that transaction costs matter "much less - if at all - if momentum is captured within an index-tracking fund". And both sets of fund managers concluded that holding value and momentum in a portfolio was good.
Well, maybe not. With the iShares new value and momentum funds in mind, I used MSCI data to test that notion. Limited data for Europe meant my source material was the MSCI World index and its 'momentum' and 'high dividend yield' sub indices, of which the latter is effectively a proxy for value.
The results of monthly returns so far this century are in the table. They show momentum comprehensively beating value and with less volatility, too. Granted, the 15 years to the end of 2014 might be untypical - I rather hope they are - even so, the results question whether it really is sensible to combine value and momentum. The gain - a small reduction in an excessive amount of volatility - seems a high price for the loss of profit.
| Momentum beats value | |||
| Momentum | Value | Combined | |
| Average | 0.36 | 0.28 | 0.31 |
| Standard Deviation | 4.52 | 4.58 | 4.29 |
| Best month | 11.6 | 13.5 | 9.9 |
| Worst month | -16.8 | -19.1 | -16.6 |
| Data for MSCI World 'Momentum' and 'High Dividend Yield' indices 2000-2014 (% change month on month) |
Rather than combining value and momentum, maybe it's better to add momentum to a diversified equity portfolio and see what happens to returns. Will it bring the benefits of higher returns and/or less volatility? What weighting of momentum is needed to have a useful impact? Is the reduction in volatility - assuming it holds - really worthwhile? These are pertinent questions that I'll apply to the Bearbull Income Portfolio next week.
