Momentum and quality are key factors that drive returns in global equity markets, with momentum outperforming across most market segments while quality offers lower volatility, according to EAM Investors CEO Travis Prentice.
“Both momentum and quality have individually generated positive excess returns across most market caps and geographies, however, their performance patterns are differentiated,” Prentice wrote in an op-ed penned for InvestorDaily.
New research from EAM Investors highlighted that both momentum and quality have distinct roles within a diversified portfolio, as they perform well under different market conditions.
In global small-cap stocks, the study found that momentum's performance edge was significant, outperforming quality by nearly 300 basis points on an annualised basis between July 1991 and April 2024.
Yet, despite momentum’s higher returns, quality remained attractive due to its lower volatility and smaller tracking error relative to the overall market.
“For emerging market small caps, for the same time period, quality underperformed the market return by 149 basis points annualised, while momentum strongly outperformed the market by 531 basis points annualised. Momentum outperformed quality with a lower tracking error with about the same volatility,” said Prentice.
At the same time, Prentice noted that 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 result in a beneficial pairing particularly in periods of major market regime shifts,” he wrote.
For investors looking to maintain a balanced portfolio, Prentice said that having exposure to the right factors is key.
“So, what is the optimal mix of strategies?...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.”
Despite what the data may say, Prentice conceded that momentum as a factor is regularly under-utilised due to its perceived risks and implementation challenges.
“However, research points towards including the factor as part of an optimised and diversified portfolio in global equity markets, especially in the case for global small caps. By incorporating momentum within this small cap universe, investors can potentially unlock a more reliable and persistent source of alpha.”
“With an evolving investment landscape, we believe that leveraging momentum strategies may prove instrumental in navigating the shifting tides of financial markets and achieving sustained outperformance,” he concluded.
To learn more from Prentice, click here.
