Growing up, my mom owned a horse farm and every year her 4-H club - and reluctantly myself - would compete in the county fair. I don’t think I ever received a ribbon and can’t say I found much excitement in the sport. However, next door to the riding ring was the cow auction, where kids would sell cows to local butchers. This, I found exciting, and beyond intriguing. It felt barbaric - or maybe served as some sort of life lesson that escapes me - that kids would raise and grow older with a cow companion only to sell it to the highest bidder. Often, the child would break down and sob after the final bid. I felt for them and always wondered how I would manage if I were in their shoes. At just 12 years old they faced the often-asked hypothetical question of “would you let your [companion of some sort] die for [X amount of money]?”
There are many parallels of the cow auction to investing in immoral companies or business practices (our thoughts on ethical investing) and the psychology of these kid’s decision still interests me today. However, for this newsletter, I want to take a turn and look at things through the cows’ eyes. Each day for over 4 years a cheery eyed innocent child comes out of their house and feeds it. With each new day the cow further confirms that the child is its friend and that humans love cows. However, on the last day, when things couldn’t be better for the cow, and its trust in the child is at its peak, the cow is sold to be slaughtered. The takeaway from this is that all evidence pointed to the child being the cow’s friend. It would have seemed foolish for the cow to think that the child would hurt him, after all the only thing the child ever did was love him!
As evidence-based investors it is important to understand the limitations of our own evidence and data. While our evidence spans over 100 years, it would be foolish to find any kind of certitude in what the future may hold solely by looking at the past. For as the cow and the turkey (picture above) have shown us, all it takes is one new data point to drastically change our thesis. Unfortunately, risk management philosophies based only upon history can be found across much of academia and by a growing number of wealth management firms across the country. I give credence to this rise in popularity because it – if you can overlook or not understand the required assumptions – makes predicting the future, which is unknown, quantifiable. It allows investment managers to look at outcomes based upon likelihoods and find comfort in knowing that statistically their clients “should be okay.” Assuming that we were able to model how likely an unknown future event was by looking at the past – which again, we cannot without faulty assumptions - statistics alone should not guide risk management. Statistically, you should survive a few rounds of Russian roulette, not die from shooting an arrow straight into the air and be able enjoy Fugu – a poisonous Japanese blowfish dish - without repercussions. However, I would lose considerable sleep knowing someone I cared about was participating in such activities. Similarly, I have found myself up at night worrying about individuals whose investment manager is blindly following (flawed) statistics.
Maybe my argument thus far is only a philosophical difference, and I have drifted far out of my vocational lane. So, let’s focus on why this risk management philosophy is misguided beyond intuition, and why the “M” word is making me extremely uncomfortable about this practice.
The risk management philosophy that has recently grown in popularity - and that makes me want yell at the top of my lungs - assumes that returns in financial markets are normally distributed. Believing this, returns can be segmented into units of likelihood – called standard deviations. Most returns will fall within 1 standard deviation of the mean – which is the most likely outcome – with progressively less and less returns occurring the farther from the mean we are, in units of standard deviations. Check out this link if you want to learn more about this practice but understanding it is not as important as knowing that it overlooks large and disastrous events in financial markets. Under this framework, the S&P 500 index – best proxy for financial markets – should only experience a monthly decline of more than 20% every 93,884,861 years. Yes, every nearly ninety-four million years - an occurrence so rare that even mentioning it sounds irrational. Yet, there has been two 20% monthly declines in the past 13 years alone! And on “Black Monday” in 1987 this happened in just one day. Just as we have seen in past financial collapses, from the fall of Long-Term Capital Management to the Great Financial Crisis, it is typically what “you know for sure that just ain’t so” that gets you in trouble. Disregarding Mark Twain’s warning, investors that follow this framework and base decisions around an obviously errant risk model will likely find themselves in scenarios they thought were nearly impossible. I just hope it doesn’t occur just as someone retires, loses their job, or their child’s tuition bill comes due.
As unnerving as wealth managers across the country drastically underestimating investment risk is, this is not what is keeping me up at night. It’s that following this “statistically should be good” risk management framework typically leads investors into riskier investments. No example of this is better than investing in momentum, or the “M” word, strategies. My father likes to tell the story of a New York stockbroker who fell out of his 60th floor window. It is said that someone in Human Resources asked how he was doing as he past the 12th floor. His reply, “so far, so good!” While obviously fictional, this story is a relatively accurate depiction of investing in momentum strategies. Like jumping off a building without a parachute, momentum strategies are fun – and can beat the market – until they inevitably hit the ground.
Momentum strategies work by buying stocks or other securities that have had high returns over the past year and selling securities whose prices have fallen. Essentially, the common investing adage of “buy low, sell high” has been replaced with “sell low, buy high, and [hopefully] sell really high.” This practice is based on evidence that shows that stocks that have performed well typically continue to do so, or at least for some time before reverting to average performance. However, when market events – usually financial or economic stress – cause reversion to the mean, momentum strategies implode. The commonly studied equally weighted momentum strategy has experienced monthly drops of −49.79%, −39.43%, −35.24% and −34.46%. And with value weighted strategies, which ETF’s such as MTUM and PDP are based upon, losses are far greater, with the worst month incurring a 64.97% loss. (1)
Exasperating my concern, is that these strategies buy investments based only upon price with no consideration for the underlying asset. Momentum investors don’t care if they are buying a company for $500,000 or $50,000,0000, only that whatever they are buying now is more expensive than it was a year ago. This makes momentum investors extremely susceptible – if not assured - to investing in financial bubbles. I am not claiming to have spotted a bubble, but it is no secret that many of the warning signs are present in some sectors of the market; exuberance, disregard for valuations, a general belief of skill by retail investors, and a dangerous mindset by many that “this time is different.”
In summation, investors in momentum strategies are riding a dangerous wave, with sharp coral below and storm clouds overhead, based upon faulty calculations and steering by looking backwards. If you are someone invested in such a strategy – likely found in your portfolio under an ETF such as MTUM, PDP, or PTBD – then please consider getting off the wave. For Sutherland Integrated clients, this has been a long-winded way of saying we are not invested in momentum strategies and likely won’t be for some time, if ever. However, we hope it demonstrates our thought process when it comes to investing. We assume very little, are agnostic in our views, could care less if a paper won a Nobel Prize, and focus extensively on the things we can control with a very healthy respect for what we can’t.
(1) Daniel, Kent D. and Jagannathan, Ravi and Kim, Soohun, Tail Risk in Momentum Strategy Returns (June 1, 2012).
Sutherland Integrated Investment Management Group, LLC is a registered investment adviser. Information presented is for educational purposes only and does not intend to make an offer or solicitation for the sale or purchase of any specific securities, investments, or investment strategies. Investments involve risk and, unless otherwise stated, are not guaranteed. Be sure to first consult with a qualified financial adviser and/or tax professional before implementing any strategy discussed herein. Past performance is not indicative of future performance.