We hope you enjoy the story of quantitative momentum.
Acknowledgments
We have had enormous support from many colleagues, friends, and family in making this book a reality. We thank our wives, Katie Gray and Meg Vogel, for their continual support and for managing our chaotic kids so we could write our manuscript. We'd also like to thank the entire team at Alpha Architect, for dealing with the two of us while we drafted the initial manuscript. David Foulke provided invaluable comments and read the manuscript so many times his head is still spinning. Walter Haynes also played a pivotal role in making the manuscript a lot better. Yang Xu was immensely helpful on the research front, grinding numbers into the late hours of the night. Finally, to the rest of the Alpha Architect team – Tian Yao, Yang Xu, Tao Wang, Pat Cleary, Carl Kanner, and Xin Song – we are forever indebted! We'd also like to thank outside readers for their early comments and incredible insights. Andrew Miller, Larry Dunn, Matt Martelli, Pat O'Shaughnessy, Gary Antonacci, and a handful of anonymous readers made the book so much better than it would have been had we been working alone. Finally, we think our editor Julie Kerr for her invaluable feedback.
About the Authors
Wesley R. Gray, PhD
After serving as a Captain in the United States Marine Corps, Dr. Gray received a PhD, and was a finance professor at Drexel University. Dr. Gray's interest in entrepreneurship and behavioral finance led him to found Alpha Architect, an asset management firm that delivers affordable active exposures for tax-sensitive investors. Dr. Gray has published four books and multiple academic articles. Wes is a regular contributor to the Wall Street Journal, Forbes, and the CFA Institute. Dr. Gray earned an MBA and a PhD in finance from the University of Chicago and graduated magna cum laude with a BS from The Wharton School of the University of Pennsylvania.
John (Jack) R. Vogel, PhD
Dr. Vogel conducts research in empirical asset pricing and behavioral finance, and has published two books and multiple academic articles. His academic background includes experience as an instructor and research assistant at Drexel University in both the Finance and Mathematics departments, as well as a Finance instructor at Villanova University. Dr. Vogel is currently a Managing Member of Alpha Architect, an SEC-Registered Investment Advisor, where he serves as the Chief Financial Officer and Co-Chief Investment Officer. He has a PhD in Finance and a MS in Mathematics from Drexel University, and graduated summa cum laude with a BS in Mathematics and Education from the University of Scranton.
Part One
Understanding Momentum
This book is organized into two parts. Part One sets out the rationale for using momentum as a systematic stock selection tool. In Chapter 1, “Less Religion; More Reason,” we provide a discussion of the two dominant investment religions: fundamental and technical. We propose that evidence-based investors consider both approaches. Next, in Chapter 2, “Why Can Active Investment Strategies Work?” we outline our sustainable active investing framework, which helps us identify why a strategy will work over the long haul (i.e., the “edge”). In Chapter 3, “Momentum Investing is Not Growth Investing,” we propose that momentum investing, like value investing, is arguably a sustainable anomaly. Finally, we end Part One with Chapter 4, “Why All Value Investors Need Momentum,” a discussion of the evidence related to momentum investing, which suggests that most investors should at least consider momentum investing when constructing their diversified investment portfolio.
CHAPTER 1
Less Religion; More Reason
Child: “Dad, are you sure Santa brought the presents?”
Father: “Yes, Santa carried them on his sleigh.”
Child: “I guess that makes sense. He did eat the cookies and milk we left by the fireplace.”
During the 1600s, the Dutch had a large merchant fleet and the port city of Amsterdam was a dominant commercial hub for trade from around the world. Based on the growing influence of the Dutch Republic, in 1602 the Dutch East India Company was founded, and its evolution into the first publicly traded global corporation drove a number of financial innovations to the Amsterdam Stock Exchange, including the subsequent listing of additional companies and even short selling.
In 1688, Joseph de la Vega, a successful Dutch merchant, wrote Confusion De Confusiones, one of the earliest known books to describe a stock exchange and stock trading. Some researchers today argue that he should be considered the father of behavioral finance. De la Vega vividly described excessive trading, overreaction, underreaction, and the disposition effect well before they were documented by modern finance journals.1
In his book, de la Vega describes the day-to-day business of the Exchange and alludes to how prices are set:
When a bull enters such a coffee-house during the Exchange hours, he is asked the price of the shares by the people present. He adds one to two per cent to the price of the day and he produces a notebook in which he pretends to put down orders. The desire to buy shares increases; and this enhances also the apprehension that there may be a further rise (for on this point we are all alike: when the prices rise, we think that they fly up high and, when they have risen high, that they will run away from us). 2
De la Vega seems to be describing how rising prices themselves can beget continued price increases. Put another way, in the words of Wes's graduate school roommate who managed a market making desk at a large Wall Street bank, “High prices attract buyers, low prices attract sellers.”3
De la Vega continues:
The fall of prices need not have a limit, and there are also unlimited possibilities for the rise…Therefore the excessively high values need not alarm you…there will always be buyers who will free you from anxiety…the bulls are optimistic with joy over the state of business affairs, which is steadily favorable to them; and their attitude is so full of [unthinking] confidence that even less favorable news does not impress them and causes no anxiety…[It seems] incompatible with philosophy that bears should sell after the reason for their sales has ceased to exist, since the philosophers teach that when the cause ceases, the effect ceases also. But if the bears obstinately go on selling, there is an effect even after the cause had disappeared. 4
Here de la Vega explicitly discusses how bulls can continue buying, and bears can continue selling, even when there is no direct reason or cause for them to do so, other than the price action itself. So here we see how, even in seventeenth-century Europe, price changes – independent of fundamentals – can affect future market prices.
While early technical analysis was evolving in stock trading in Europe, an even more fascinating financial experiment was taking place in Japan. During the 1600s, the peasant class, who made up the majority of the Japanese population, was forced into