Look hard enough and you will find momentum in every nook and cranny of the market. It’s not just funds that overtly select stocks based on their recent outperformance (what Woolley calls “elective momentum”) or investors seeking to reduce tracking error (“forced momentum”). Retail investors are invariably attracted to hot stocks. Systematic traders, such as so-called commodity trading advisors and many hedge funds, are trend-followers. Selling an underperforming fund and putting the proceeds into a competitor with a superior recent track record constitutes momentum. Shifting from an active manager to an index fund has a similar effect.
There’s more momentum around today than ever. Active fund managers constitute around 10% of the turnover of the U.S. stock market, down from 80% three decades ago, according to CBOE Global Markets. Retail investors attracted by commission-free trading on smartphone apps, such as the one operated by Robinhood Markets, are dominant. Trillions of investment dollars have shifted from actively managed to passive vehicles in recent years.
When people are uncertain about the future, says Woolley, they follow the herd. Since the prospective returns from investments in artificial intelligence are unknowable, investors are inclined to chase recent outperformers. That explains why the exposure of hedge funds to high-flying semiconductor and hardware stocks has gone parabolic.
In the late 1990s, momentum was on a tear. Value managers who failed to keep up with their benchmarks suffered massive outflows. GMO’s asset allocation division, overseen by Grantham, lost around half its assets under management. History appears to be repeating itself.
In his most recent letter to investors, Terry Smith, the CEO of Fundsmith, observes that momentum in the U.S. stock market is “at a 30 year high and more extreme than in late 1999 just before the Dotcom bubble burst. As active fund performance continues to worsen, people abandon it, producing a vicious feedback loop.”
The Fundsmith Equity Fund returned -2.9% in the first six months of the year, trailing the MSCI World Index by over 14 points in sterling terms. Many clients have had enough: The assets under management of its flagship fund declined from £28.9 billion in 2021 to £12.3 billion at the end of June.
Smith is responding to this disappointing performance by changing his approach. Whereas before the firm’s investment mantra was to buy good companies at the right price and do nothing else, Smith now says it “will take more account of momentum.” This change of direction pushed portfolio turnover above 50% in the first half of the year. Fundsmith has sold some underperforming positions, replacing them in part with beneficiaries of the ongoing AI investment boom, including Taiwanese chip giant TSMC, turbine supplier GE Vernova and marketing platform AppLovin.
Woolley believes these moves are misguided. Nevertheless, Fundsmith provides a real-time demonstration of the mechanisms he and Vayanos describe. The firm’s investment process is now explicitly constrained by client flows.
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