Just as we step into the end of the calendar year, here’s our performance as of November end:

It’s been a rough year or so for momentum, though the last fortnight (first 15 days of December) have seen a very strong recovery. It’s par for the course that a strategy like momentum will have periods of underperformance, but we are constantly checking on how things should improve and how we should control deep downside risks.

Anoop has a fairly detailed post (which follows) on what the factors of recent underperformance are and what we are doing to address it. 

9/11 and Airline Safety

After the terror attacks in the US on 9/11, the Federal Aviation Administration (FAA) developed a set of requirements for cockpit doors for the nearly 6,000 commercial aircraft in use in the US.

The requirements called for reinforced doors that were locked/unlocked from inside the cockpit to prevent hijackers from taking control of the aircraft, thereby preventing similar future terrorist attacks.

Only this was not the first time that such an idea had been proposed.

Over 30 years before 9/11, Dr Constantin Lent, a mechanical engineer holding multiple patents, wrote to the White House about the need for locked cockpit doors on aircraft to prevent possible hijackings. Numerous hijackings in Europe in the late 1960s prompted his letter.

His proposal was a simple one: to introduce a reinforced door controlling access to the cockpit, controllable only from the inside.

The vice president’s office acknowledged Dr Lent’s letter and sent it to the FAA, asking them to consider implementing the proposal. The FAA invited comments from the airline industry and the general public. The airline industry was against the proposals, presumably because of the additional cost involved (The cost estimate in 2002 when the measures were mandated was estimated at between $300M and $500M for the airline industry.)

The 2008 GFC and Risk Management in Momentum Strategies

For those who might remember, 2008 was the last big stock market crash in relatively recent history. Over the course of the year, markets the world over lost more than half their value.

Consider these drawdown charts of the Nifty along with two popular momentum indices.

The Nifty fell by 58% from its peak in early 2008 while the Momentum Indices fell by up to 70%.

The next chart shows the difference in drawdown between the Momentum indices with the Nifty. Negative values imply how much more the indices fell than the Nifty at the time, and positive values imply they fell less than the Nifty.

The now well-known momentum indices fell by more than 30% than the Nifty over the course of the 2008 correction and subsequent recovery. It took the Momentum indices ~6 years to regain their 2008 peak.

When we worked on building our Momentum strategy, we were acutely aware of the possibility, albeit low, of such events and wanted to “install the doors” before a catastrophic 2008-type event occurred. Keep in mind, that the first real-world funds tracking the momentum index were launched in 2021, in the middle of the post-pandemic bull market.

And so when we went live with our Momentum strategy in 2019, we:

1. Adopted a higher rebalance frequency. 6 months—as followed by the indices being too risky. 
2. Beyond just momentum ranks, included a set of conditions when failed, led to stocks being exit. For context, the momentum indices don’t exit stocks between rebalances. 

This worked, as intended when the next deep correction came in 2020—Our Momentum strategy fell -15% compared to -40% for the Momentum indices and Nifty.

However, since then, those same risk-management measures have resulted in faster exits from stocks after periods of weakness, which, over the last 2 years, have been followed regularly by rapid bouncebacks. Essentially, no correction has been long-lived.

In a way, the risk-management measures meant to protect against catastrophic damage have led to medium-term underperformance versus other momentum strategies.

In the medium term, in the absence of any hijack attempts, the reinforced cockpit doors are an added cost due to their weight. Long-term, the cost of installing those doors has been well worth it, as it shows in the long-term performance of our Momentum strategy.

Can we reduce the cost of risk management?

We periodically review the parameters in use in the momentum stock selection model for their continued effectiveness and areas for improvement.

Our options to address underperformance:

1. Drop the risk-management measures entirely (no stock-level exit conditions, longer rebalance cycles) and hope 2008 / 2020-type events don’t occur in the future OR
2. Modify risk-management measures to give stocks more time while being responsive enough in steep correction events. (Note: corrections under 30% don’t count as steep and should be considered par for the course for investing in equities). 

We’ve chosen #2, modifying some of the conditions that trigger stock exits while retaining broad market-level triggers that will cause a movement out of equities.

Our rebalance / review cycle will continue to be short on a rolling basis while looking to reduce the impact of whipsaws when market conditions weaken briefly only to recover.

These modifications should balance allocation risk management with continued exposure to momentum stocks which should help with continuing to achieve our stated objectives of strong long-term risk-adjusted returns.

We’ll closely monitor how these changes play out in the real world. Remember, our objective is not to rise and fall in line with other momentum strategies but to deliver sustainable and healthy long-term returns. 

I’ll reiterate that the probability of momentum outperforming the benchmarks goes up significantly in line with holding periods - lower over periods of 12-18-24 months and significantly higher over holding periods over 36 months. 

For most investment strategies that have endured, the optimal times to allocate, in hindsight, tend to be when they’ve undergone periods of ordinary returns. Our real-world experience says Momentum is no different.

Looking forward,

Anoop and Deepak