Momentum and quality are key factors in an optimised portfolio
The article was first published in Investors Daily on 17 September 2024
Global asset markets are made up of dozens of asset classes and millions of individual securities. Within all this, there are a few important factors that drive returns. These factors are driven by different economic fundamentals and tend to outperform at different times. Therefore, it’s important to consider maintaining exposure to those factors that offer complementary outcomes.
Momentum and quality are two such factors. They have each individually generated positive excess returns across most market caps and geographies, according to Travis Prentice, portfolio manager of the EAM Global Small Companies Fund, distributed in Australia by SG Hiscock & Company. However, their performance patterns are differentiated.
“Momentum has been the best performing factor in global equity markets for small cap, mid caps and large caps stocks, so it is a highly significant equity premium” said Mr. Prentice after examining returns from each factor in global stock markets in a new research paper, Momentum and Quality. “Momentum” investing refers to buying companies with strong performance trends.
Quality outperforms the market, as well, everywhere except for in emerging markets small cap. However, quality tends to exhibit lower volatility than momentum. There are many ways to define quality, but a common component typically includes companies with healthy balance sheets or operating profitability.
EAM’s latest research looks at the relationship between momentum and quality across different sub-segments of global equity markets. In global small cap, for example, both momentum and quality have outperformed the market return over the entire sample period from July 1991 to April 2024. However, momentum outperformed quality by nearly 300 basis points on an annualised basis in the period. Quality displays a much lower tracking error to the market and lower volatility than momentum. Still, momentum exhibited superior risk adjusted returns in the period as measured by higher Sharpe and information ratios.
The relationship between momentum and quality has fluctuated significantly over time. Correlations have trended increasingly negative in recent periods, particularly in US small cap and emerging markets. “Generally, the varying degrees of relationship between momentum and quality results in a beneficial pairing particularly in periods of major market regime shifts,” said Mr. Prentice.
For investors looking to maintain a balanced portfolio, having exposure to the right factors is key. EAM’s research piece looks at momentum and quality along with other prominent style factors – value and growth – to determine what an optimal mix of strategies might look like.
“This analysis points to an optimal blend of strategies through maximising the information ratio, by combining momentum and quality in a diversified portfolio, or using momentum as a stand-alone satellite due to its leading risk/return characteristics” Mr Prentice said.
Results in global small cap show a blend of quality, momentum and value yields the highest information ratio. Growth is noticeably absent due to its inferior risk/returns characteristics in the global small cap universe.
EAM Global Investors employs their proprietary Informed Momentum® investment approach which leverages collective insight within a systematic process which incorporates momentum, stock selection, tailored risk management and efficient implementation – designed to maximise alpha.
“Momentum is often misunderstood and underutilsed due to its perceived risks and implementation challenges, however research points towards including the factor as part of an optimized portfolio.” Said Mr. Prentice.
Investors can gain exposure to EAM Investors’ Informed Momentum® through the EAM Global Small Companies Fund, distributed in Australia by SG Hiscock & Company.
For more information visit the EAM Global Small Companies Fund page.
SG Hiscock & Company has prepared this article for general information purposes only. It does not contain investment recommendations nor provide investment advice. Neither SG Hiscock & Company nor its related entities, directors or officers guarantees the performance of, or the repayment of capital or income invested in the Funds. Past performance is not necessarily indicative of future performance. Professional investment advice can help you determine your tolerance to risk as well as your need to attain a particular return on your investment. We strongly encourage you to obtain detailed professional advice and to read the relevant Product Disclosure Statement and Target Market Determination, if appropriate, in full before making an investment decision.
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