Cap-Weighted Benchmarks: Good Momentum Bets?

No, they are not.

July 2020. Reading Time: 10 Minutes. Author: Rodolfo Martell.

SUMMARY

  • After strong momentum rallies, investors frequently ask if cap-weighted benchmarks are good Momentum bets
  • Factor exposure analysis shows this is not the case
  • Investors should seek smart beta and long-short products if they want Momentum exposure

INTRODUCTION

Old myths are hard to kill. Good old myths are nearly impossible to kill. Good old myths with elements of pseudo credibility are like crabgrass in a well-manicured lawn: you can count on it to make an attempt at comeback every season. Think of Area 51 or the conspiracy theories about the faking of the moon landing.

Proponents of those myths tend to grab to isolated facts that, on their own (and in a vacuum), could be correct but when looked in the complete context they just don’t support the myth. For instance, defenders of the lunar landing hoax claim that the picture of the flag on the moon is proof of their theory (how can it be waived if there is no atmosphere), however, when you read the explanation regarding the malfunctioning telescoping rod, everything makes sense. What is more likely: a malfunctioning piece of equipment after having suffered hours of extended G-forces or 100,000 people across the space program being part of a massive hoax? Occam’s razor supports the former and not the latter as a plausible explanation, and so do we.

In factor land, one ugly myth, like a zombie that refuses to die in a B Hollywood movie, is that the market capitalization-weighted benchmark is a good Momentum bet. Academics and practitioners have written many articles and notes trying to dispel this notion… and yet, every few years the myth resurfaces – particularly after Momentum has had a good run.

One crucial element that can add to the cyclical revival of this question is that, in good times, people like to point out the Momentum in the benchmark, which is very different from the benchmark being a good vehicle for Momentum.

In this short research note, we will contribute to the efforts done before to discredit this myth, and hopefully add to the growing body of work that is trying to cut as many heads as possible from this hydra.

MOMENTUM IN THE BENCHMARK

Let us take a few minutes to remind ourselves what is Momentum. We know that