What Are the Momentum and Quality Factors

The momentum factor refers to the 'tendency of stocks that have risen a lot recently to keep rising for a while, and stocks that have fallen a lot to keep lagging for a while.'

Usually you split winners and losers by the trailing 12-month return (excluding the most recent 1 month). You hold winners and avoid losers.

Interestingly, among various factors (value, size, profitability, quality), momentum is sometimes assessed as having historically delivered the highest premium. But the risk is just as large.

Momentum's biggest weakness is the 'crash.' When the market suddenly rebounds after a sharp fall, the loser stocks that had fallen the most explode upward, and because a momentum strategy was avoiding exactly those losers, it misses the sharp rebound and takes large losses.

A representative case is 2009. Over just three months from March to May 2009, momentum strategies plunged more than 73%. During this period the former-loser group jumped +163%, while the former-winner group managed only +8%.

At the time, the losers were stocks that had fallen an average of -84% from their peaks in the financial crisis and then rebounded sharply after surviving bankruptcy scares. Momentum is strong in normal times but can collapse badly at such turning points.

The quality factor refers to the 'tendency of financially robust companies to deliver better risk-adjusted returns over the long run.'

Here, the criteria for a 'good company' are usually high ROE (return on equity), stable earnings, low debt (a low debt ratio), and sustainable growth. In fact, ROE and the debt-to-equity ratio (D/E) are cited as the best-working quality metrics.

Quality often shows a 'defensive' character that shakes relatively less in down markets.

Quality's trap is that 'a good company is not necessarily a good investment.' Companies reputed to be excellent are often already trading expensively (at high valuations). If you buy at an expensive price, even a great company may not deliver returns as expected.

And there is a limit shared by all factors. Any factor can underperform for several years or more, and there is no guarantee the premium will persist in the future.

So momentum, quality, and value each show their strengths in different phases, and many approaches try to strike a balance by mixing factors with different characters rather than concentrating on one. That said, this is an explanation of the concept, not a recommendation of any particular strategy.