Mean Reversion and Momentum

This article is reprinted from the Indexology blog of S&P Dow Jones Indices.

After almost four years of underperformance, we witnessed a change in fortune in February 2021, as the relative performance of the S&P 500® Equal Weight Index turned positive. By the end of April, Equal Weight had outperformed the S&P 500 by 11% over the prior 12 months, as we see in Exhibit 1.

Equal Weight’s recent rebound naturally had an impact on its factor exposures, particularly for the momentum factor. To provide context, in Exhibit 2, we plot the annual relative performance of Equal Weight on the x-axis and Equal Weight’s (risk-adjusted) momentum exposure on the y-axis, including the most recent 12-month period, as of April 30, 2021.

There is a strong positive relationship between relative performance and momentum, with an R2 of 0.60. Unsurprisingly, when Equal Weight is doing well, its momentum score rises. But over time, despite Equal Weight’s outperformance (averaging 2.5% over 22 calendar years), its momentum score is typically negative, at a median of -7.6%. This is a function of the way Equal Weight rebalances—every quarter, it sells its relative outperformers and buys more of its relative underperformers, which has the effect of muting its exposure to the momentum factor.

Interestingly, Equal Weight’s momentum exposure is currently flat. This last occurred at the end of 2016, as Equal Weight’s relative performance turned positive. Equal Weight experienced the strongest positive momentum exposures when its outperformance was at a peak, such as in 2001, 2003, and 2010.

To provide further context, Exhibit 3 shows a time-series of the historical momentum exposures of the S&P 500 Equal Weight Index. What is striking is the speed with which Equal Weight’s tilt against momentum in December 2020 was neutralized by the end of April 2021, paralleling the swiftness of its performance rebound.

The recent comeback of smaller caps and Equal Weight, resulting in a neutral exposure to momentum, indicates a moderately strong relative return environment. It is important to remember that factor exposures are not constant and experience fluctuations as we experience reversals in performance. If Equal Weight’s outperformance continues, we can anticipate a further increase in its exposure to momentum. We can look to history to provide perspective on these changing relationships.

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