Callan's director of Hedge Fund Research, Jim McKee, explores the advantages of momentum-based investing strategies, which profit from market trends in whichever direction. He discusses the rationale behind them, how they are defined and harnessed for different diversification needs, and whether they are appropriate for fund sponsors.

1. Knowledge. Experience. Integrity.
Jim McKee is the director of Callan’s Hedge Fund Research
group. He specializes in hedge fund research addressing related
issues of asset allocation, manager structure, manager search,
and performance evaluation for Callan’s institutional clients.
CALLAN
INSTITUTE
Research
October 2016
Momentum
The Trend Is Your Friend
With investors facing divergent scenarios of inflation or recession in which prices of all assets can go
in radically new directions, now may be the time to consider momentum-based strategies.
These approaches profit from distinct trends—in whichever direction—and reflect the reality that fear
and greed fuel herding behavior by investors.
Academic research has shown that trend-following strategies can complement a balanced portfolio of
stocks and bonds.
This essay was originally published in the second quarter 2016 edition of Hedge Fund Monitor.

2. 2
‘Houston, We’ve Had a Problem Here’
On April 13, 1970, two days after Apollo 13’s lift-off, the spacecraft’s oxygen tank exploded 200,000 miles
from Earth. Lacking enough power to land on the moon and return home, the crew focused on returning
to Earth safely. After a sling shot around the moon propelled by its gravitational force, the crippled Apollo
13 could only tweak its trajectory toward Earth while hoping for a soft landing. Too shallow a path into
the Earth’s atmosphere would carry it off into infinite space. Too sharp a path would burn up the helpless
vessel. As fate played its card, Apollo 13 fell safely into the ocean, avoiding the unpleasant alternatives
of a fiery finish or endless purgatory.1
Today, the world’s central bankers face a similar, albeit less dramatic, dilemma. Over the last 35 years,
they have had plenty of fuel from lowering interest rates to keep economies aloft while avoiding hard
landings. With rates at zero, more or less, these central bankers have lost their conventional power to
lift their economies, which are at risk of stalling. Their remaining levers of “quantitative easing” and other
risk-promoting tools can tweak economic trajectories, but only on the margin.
If central banks ease conditions too much, an economy can slide helplessly toward potentially unstoppa-
ble inflation, like Zimbabwe in 2008. If too little, the economy can experience a hard landing, like Greece
today. With just the right policies to make sure economic growth outpaces debt growth, a safe landing is
possible. However, the margin of error for policy makers between the socially destabilizing fates of a hard
landing and inflation has never been tighter.
“If you’re going through hell, keep going.” – Winston Churchill
Get Your Mojo Workin’
A sense of increasing uncertainty looms for investors facing these divergent scenarios of inflation and
recession. If policy makers are unable to steer clear of recession, stock investors will likely suffer steep
losses. If the central bank printing press runs too fast, bond holders will face tremendous losses when
interest rates spike. If consumer demand fails to respond sufficiently to further stimulus stoked by the
printing press, stocks will likely reverse their long trend up from their last cyclical bottom in 2009.
Given this environment, investors face a prospective inflection point in which prices of all assets can go in
radically new directions. Consequently, today is a good time to consider momentum-based strategies that
profit from distinct trends in whichever direction, particularly when long-only investments are at risk of fall-
ing. In this paper, we look at the rationale behind these approaches, how they are defined and harnessed
for different diversification needs, and whether they are appropriate for fund sponsors.
“Trends that can’t continue won’t.” – Herbert Stein
1 Apollo Expeditions to the Moon, ed. Edgar M. Cortright. Washington, D.C.: National Aeronautics and Space Administration, 1975,
p. 245-263.
The margin of error for
policy makers between
the socially destabilizing
fates of a hard landing
and inflation has never
been tighter.

3. 3Knowledge. Experience. Integrity.
Momentum as a Risk Premium
When momentum is in your favor, it is a beautiful thing. Unlike long-only stocks or bonds, it is not
beholden to any economic forecast. The investment rationale behind momentum strategies and their
durability as a positive risk premium has many supporting arguments. While efficient market theory
argues that market prices reflect all known information instantly, in reality fear and greed fuel herding
behavior by investors. First, investors typically underreact to new information affecting market prices.
As that new information gets assimilated by the market, prices tend to trend further as more investors
buy into the story. Investors’ behavioral shortcomings, such as confirmation bias, help to support these
trending behaviors in market prices. Seasonal events, such as tax-related selling when investors prune
losing positions to generate a realized loss, can reinforce trending patterns. The final phase of a mar-
ket trend reflects a delayed overreaction in which prevailing investor sentiment pushes prices past fair
underlying value, setting the stage for a trend’s reversal. When market equilibrium shifts in the wake
of new information or in the transition from one economic cycle to another, the rules-based process
behind momentum strategies responds to the new direction in an unbiased manner.
The excess returns of trend-following over cash are particularly attractive during periods of market volatility
and shifting economic cycles. The high trading activity needed to execute a trend-following strategy, though,
demands an efficient, disciplined implementation process. As with any investment strategy, an attractive op-
portunity burdened by excessive management fees and transaction costs can quickly become unattractive.
“Often the only difference between winning and losing is momentum.” – John C. Maxwell
The Choice Is Yours
Price-based momentum strategies take two distinct formats serving different investment objectives. Giv-
en the often uncorrelated behavior of trend-following with long-only investments, they are compelling
diversifiers beside an existing stock and bond portfolio.
• Price Momentum: This strategy is focused on capturing nominal price trends across liquid markets
(i.e., stocks, bonds, currencies, commodities). Many studies document the positive excess returns from
this strategy,2
including one from 1990.3
Whether long or short, the strategy’s underlying components
are directionally exposed to market beta. The key to creating attractive risk-adjusted excess returns
is diversification across dozens or hundreds of markets, each sized for its respective risk contribution.
The time frames for targeting trends can be short (e.g., one month), medium (three months), long (12
months), or a combination.4
This strategy uses liquid index-derivative contracts (e.g., equity futures,
bond futures, currency forwards, and commodity futures). If a market’s trend signal is strong, the strat-
egy adds that market’s exposure, whether long or short. In markets with declining price trends, this
strategy normally has a negative correlation with equity risk and consequently tends to add value to
2 Tobias J. Moskowitz, “Time Series Momentum.” Journal of Financial Economics. Volume 104, Issue 2, May 2012, pp. 228-250.
(http://www.sciencedirect.com/science/article/pii/S0304405X11002613)
3 Narasimhan Jegadeesh, “Evidence of Predictable Behavior of Security Returns.” The Journal of Finance. Volume 45, Issue 3, July
1990, pp. 881-898. (http://m.e-m-h.org/Jega90.pdf)
4 Price movements within shorter time frames can involve more statistical noise and fewer signals, therefore making them less attrac-
tive for trend-following strategies. Time frames longer than one year do not adjust frequently enough to capture trends or provide
the desired diversifying benefits compared to a traditional buy-and-hold portfolio.
The excess returns of
trend-following over cash
are particularly attractive
during periods of market
volatility and shifting eco-
nomic cycles.

4. 4
the total portfolio. In markets trending up, the strategy’s correlation tends to be positive while its returns
remain additive. However, in flat or range-bound markets, trend-following strategies tend to lose their
value-added purpose.
• Spread Momentum: Unlike price momentum, the spread momentum approach seeks to capture the
momentum risk factor between related securities or asset classes. For example, when ranked by degrees
of momentum exposure over short, medium, and long time frames, securities exhibiting the most momen-
tum are held long while those with the least are held short. In contrast to the price momentum strategy,
the spread momentum strategy excludes explicit beta or market risk. Various studies5
have documented
evidence of positive excess returns from this strategy. Since this specific risk exposure hedges out the
broad market’s volatility, this strategy may use leverage to amplify its returns. However, sudden reversals
of securities with relatively attractive momentum characteristics can be painful and occur at the same time
as market-related reversals. Meanwhile, other style risk factors, such as value or defensive, are likely
to perform well with lower or even negative correlation to momentum. Given this statistical relationship,
which is also true for price momentum, this strategy can be a more effective diversifier when an investor’s
total portfolio has already reached the limits of its market risk budget.
Another “momentum” approach based on underlying fundamental factors warrants a comment. Funda-
mental momentum focuses on trends, positive or negative, in earnings, sales, or other metrics of corpo-
rate or economic growth. Like price momentum, the premise behind this strategy is the belief that inves-
tors initially underreact to changes in fundamental metrics. Subsequently confirmed fundamentals lead
more investors to adopt that security’s narrative. As the trending fundamentals pick up more followers,
the trend climaxes with future earnings forecasts that are too pessimistic or optimistic. The performance
pattern of this strategy correlates with factors used for selecting growth-oriented stocks. Given that funda-
mental momentum is a highly subjective measure compared to price-based momentum and is influenced
more by economic or sales cycles, it has a less significant role in most trend-following applications.
“In investing, what is comfortable is rarely profitable.” – Robert Arnott
When a Trend Goes Out of Style
Like any fashion trend that reaches its final stage of popularity, an overcrowded trade with no new converts
behind it will encounter resistance and reverse direction. Such reversals can be sudden and not tied to new
information. Since these dislocations are so unpredictable, trend-following strategies are vulnerable to sud-
den bouts of volatility. While volatility is important to keep trends in motion, too much of it can destabilize
any established trend. As George Soros noted, “When a long-term trend loses its momentum, short-term
volatility tends to rise. It is easy to see why that should be so: the trend-following crowd is disoriented.”
Sudden market reversals, such as those in March 2009, can be costly to trend-followers, but they become
part of the next signal to reverse positions or at least be neutral. This constant need to adapt is why ac-
tive risk management plays a significant role for momentum-based strategies, in contrast to buy-and-hold
strategies. Systematically cutting losers while letting winners ride is the essence behind success in cap-
turing the risk premium from momentum strategies. When trends disappear and uncertainty increases,
risk exposures need to be pulled down until market signals overcome noise.
5 Clifford Asness, Andrea Frazzini, Ronen Israel, and Tobias Moskowitz, “Fact, Fiction and Momentum Investing.” Journal of Portfolio
Management, Volume 40, No. 5, Fall 2014, pp. 75-92. (www.aqr.com/library/journal-articles/fact-fiction-and-momentum-investing)
Trend-following strategies
are vulnerable to sudden
bouts of volatility.

5. 5Knowledge. Experience. Integrity.
In addition to sudden inflection points that reverse a trend, a market with no discernable trend threatens
any trend-follower’s success. Range-bound markets typically create high turnover of market exposures,
long and short, as trend-following models unproductively cycle in and out of positions. Such high turnover
involves more trading losses and operating expenses.
For those inevitable spells of trendless markets, managers of trend-following strategies add diversifica-
tion strategies such as mean-reversion, carry or other value-oriented techniques to generate incremental
profits. Such extra exposures together with momentum give the combined investment strategy a more
attractive risk-adjusted profile as a standalone product. These added diversifiers may have less strategy
capacity or require more proprietary research than rules-based momentum and therefore cost more.
In some instances, these diversifiers with low correlation to momentum risk are correlated with similar
risk factors elsewhere in the fund sponsor’s portfolio, like value-oriented stocks and income-generating
bonds, as well as any active rebalancing program. Consequently, investors who have well-diversified fac-
tor exposures elsewhere to complement momentum risk and can accept the long-term cyclical patterns of
undiversified momentum risk may be better served by a pure trend-following strategy. This is especially
true if it can be implemented at a lower cost.
“Trendy is the last stage before tacky.” – Karl Lagerfeld
Diversity Is Good for Business
Investing based on price trends is contrary to the core beliefs of many value investors. However, even
Warren Buffett would be hard-pressed today to find any meaningful assets selling at an attractive dis-
count, as prospective returns for stocks, bonds, and other cash-generating assets are in the mid-single
digits, at best. While Buffett is famous for claiming to “be fearful when others are greedy and greedy when
others are fearful,” what does one do when markets are moving between these emotional extremes?
Trend-following strategies help to complement a balanced portfolio of stocks and bonds.
To illustrate performance for price momentum strategies, we used three peer group index proxies: Cred-
it Suisse Managed Futures Index, BarclayHedge BTOP50 Index, and SocGen Trend Index (formerly
Newedge Trend Index). These are not pure expressions of the strategies, given the typical manager’s
propensity to add other diversifying approaches, but trend-following is a substantial component of each
index’s returns. The correlation of these trend-following indices with the S&P 500 over rolling three-year
periods ranges between -0.5 and +0.7 (Exhibit 1). Notably, these indices have typically been rising when
stocks were falling.
But trend-following strategies should not be considered as explicit portfolio hedges. Rather, they are sim-
ply an additional source of uncorrelated returns. Although trend-following returns tend to be uncorrelated
with other investments over the long run, their correlations with equity and other growth-oriented risks can
be volatile over shorter time horizons and may not be as low as expected during crisis conditions.
“The dumbest reason in the world to buy a stock is because it’s going up.” – Warren Buffett
Even Warren Buffett
would be hard-pressed
today to find any mean-
ingful assets selling at an
attractive discount.

6. 6
Show Me the Money
Far be it from us to argue with Warren Buffett—but we will. To support academic claims of trend-fol-
lowing’s positive excess returns over cash, we compared the cumulative returns of a trend-following
index (BarclayHedge BTOP50) versus stocks (S&P 500) and bonds (Barclays Aggregate) since 1987.6
BTOP50’s cumulative returns since its inception land between the S&P 500 and Barclays Aggregate, well
above cash, net of underlying manager fees (Exhibit 2).
1,590.37%
174.29%
548.01%
-250%
0%
250%
500%
750%
1,000%
1,250%
1,500%
1,750%
09 10 11 12 13 14 1508
CumulativeReturns
16070605040302010099989796959493929190898887
Declining periods (S&P 500)3-Month T-Bill
Barclays AggregateS&P 500 BarclayHedge BTOP50
854.00%
Sources: Barclays, BarclayHedge, Federal Reserve, Standard & Poor’s.
6 The available history of BarclayHedge BTOP50 Index begins on January 1, 1987.
Sources: Barclays, BarclayHedge, Credit Suisse Hedge Fund Index, Standard & Poor’s, Societe Generale.
1.00
0.01
-0.05
Credit Suisse Managed Futures
09 10 11 12 13 14 1508
Correlation
160706050403020100999897969594939291
-1.0
-0.5
0.0
0.5
1.0
0.02
SocGen Trend Index
-0.07
Barclays AggregateS&P 500 BarclayHedge BTOP50
Exhibit 1
Rolling 36-Month
Correlation vs. S&P
500 Index for 25 Years
ended June 30, 2016
Exhibit 2
Cumulative Returns
since January 1, 1987

7. 7Knowledge. Experience. Integrity.
Compared to the S&P 500, bonds and trend-following strategies show a similar performance pattern
over market cycles (Exhibit 3). During declining markets, both bonds and trend-following have provided
offsetting returns that can smooth out returns in a broadly diversified portfolio, albeit for different reasons.
Income with principal protection lifts bonds, while major moves from stocks and bonds usually provide
profits for trend followers.
Performance for all asset classes will likely be very different than it was for the last 30 years, which was
marked by declining interest rates. Low bond yields today are indicative of bond returns tomorrow. High
stock multiples with low dividend yields are also predictive of returns for equities. Since significant cash
balances are held in margin accounts for underlying derivative positions of trend followers, today’s low
interest rates are also hurting their prospective nominal returns. In contrast to stocks dependent on eco-
nomic growth and bonds dependent on stable inflation, the future for trend-following will lean on neither
of those. Instead, it will depend on market volatility and uncorrelated movements between stocks, bonds,
currencies, and commodities to sustain profitable trends and diversifying benefits. Transaction costs and
fees will also be an important consideration, as lower return expectations make it tougher to justify
expenses being charged by managers and their service providers.
Make Your Own Mojo
Given its foundation on the timeless ebbs and flows of fear and greed, momentum has staying power as a
positive long-term risk premium. Whether momentum is captured in absolute or relative terms, this strategy
focused on identifying and riding trends across stocks, bonds, currencies, and commodities requires much
more disciplined risk management than traditional buy-and-hold strategies. The unpredictable nature of
market cycle timing does leave this strategy vulnerable to both sudden market reversals and range-bound
markets. However, given today’s combination of increasingly return-starved investors and slowing economic
growth, markets crashing to earth or spinning out of orbit are palpable risks. Being prepared to embrace
either direction is the diversifying edge behind trend-following strategies. Otherwise, like the crew of Apollo
13, investors should fasten their seatbelts for a bumpier ride.
0.00%
-61.66%
-83.77%
-100%
-50%
0%
50%
100%
09 10 11 12 13 14 1508 16070605040302010099989796959493929190898887
CumulativeRelativeReturns
-43.56%
Declining periods (S&P 500)3-Month T-Bill
Barclays AggregateS&P 500 BarclayHedge BTOP50
Sources: Barclays, BarclayHedge, Federal Reserve, Standard & Poor’s.
Exhibit 3
Cumulative Returns
Relative to the
S&P 500 Index
since January 1, 1987
Given its foundation on
the timeless ebbs and
flows of fear and greed,
momentum has staying
power as a positive long-
term risk premium.

8. 8
About the Author
James C. McKee is a Senior Vice President and Director of Callan’s Hedge Fund Research group. Jim
specializes in hedge fund research addressing related issues of asset allocation, manager structure,
manager search, and performance evaluation for Callan’s institutional clients. Jim is a shareholder of
the firm.
Jim joined Callan in 1989. Prior to his career at Callan, Jim worked with the Pacific Stock Exchange
(PSE) from 1982 to 1989. Until 1985, Jim worked on the PSE’s options trading floor. Thereafter, as man-
ager of the PSE’s securities research department, he was responsible for developing and monitoring
new stock, bond, and option listings.
Jim earned an MBA in Finance from Golden Gate University in 1987. His graduate studies focused
particularly on publicly traded securities and capital markets. He received his BA in Economics/Environ-
mental Studies from Dartmouth College in 1982.

9. 9Knowledge. Experience. Integrity.
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