Using momentum and hedge fund strategies can be good ways to build a better portfolio.
A momentum stock is generally defined as one with high or accelerating returns over a previous three-to-12-month period, says Hal Ratner, global head of research at Morningstar Investment Management, a unit of Morningstar Inc. in Chicago.
There is some evidence that momentum stocks exhibit fundamental characteristics such as high volatility of revenue growth, low cost of goods sold and high market-to-book value, he says.
However, there is no particular reason why these are, in and of themselves, desirable characteristics.
“One reason that momentum can get a bad rap is that it is entirely dependent on timing and sensitive to trading costs,” Ratner says. “It can also be much riskier than other forms of investing.”
That said, momentum is negatively correlated with the broad equity market over longer-term horizons and can add diversification to a portfolio with a focus on more value-oriented investments, “but it is extremely skill-dependent,” Ratner says.
Although 2015 rewarded momentum stocks, this year is rewarding companies with strong fundamental characteristics, says Anthony Davidow, alternative-beta and asset allocation strategist at the Schwab Center for Financial Research in New York.
Many advisers are beginning to view momentum and fundamentals as complements to one another, he says.
They have moved beyond the question of “do these strategies work?” to “how can I use them to build portfolios?” Davidow says.
“We believe that this is a positive development for the industry,” he says.
“Not all smart-beta strategies are created equally. If advisers understand how these strategies work, they can use these tools more effectively,” Davidow says.
Within hedge funds, Bank of the West’s Wealth Management Group in Denver employs many different strategies, says Wade Balliet, executive vice president and head of investment advisory and management.
“We try to strategically position our macro asset classes with tactical weightings,” Balliet says.
“Depending upon the client’s overall return and risk parameters, we then try to strategically match different alternative assets to position them to do well in different environments.”
One of the asset classes that the team uses is reinsurance vehicles to lower the overall volatility in the portfolio, Balliet says.
Such vehicles are tied to weather-related and catastrophe-related events and have low correlation with stocks and bonds. Even though the vehicles exhibit more characteristics of bonds, they have zero duration, i.e., clients aren’t buying 10- or 15-year debt but rather a short-term note, in which they receive yield for the reinsurance risk.
“The asset class, like any other investment, doesn’t provide 100% certainty, but the potential for consistent positive absolute-value return in the marketplace is a high probability,” Balliet says.
This story is part of a 30-30 series on ways to build a better portfolio.