Disclaimer: I am not an investment advisor and this should not be taken as investment advice. This content is for informational purposes only. Please do your own research or seek professional advice and otherwise take reasonable precautions before making any significant investment decisions.

Confidence: Likely1

Hauke Hillebrandt explains mission hedging:2

How should a foundation whose only mission is to prevent dangerous climate change invest their endowment? Surprisingly, in order to maximize expected utility, it might use ‘mission hedging’ investment principles and invest in fossil fuel stocks. This way it has more money to give to organisations that combat climate change when more fossil fuels are burned, fossil fuel stocks go up and climate change will get particularly bad. When fewer fossil fuels are burnt and fossil fuels stocks go down - the foundation will have less money, but it does not need the money as much.

But mission hedging has a big downside: it reduces diversification, which hurts your risk-adjusted return.

The momentum premium: “stocks with low returns over the last year tend to have low returns for the next few months and stocks with high past returns tend to have high future returns.”3 Investors can take advantage of the momentum premium by buying stocks that have gone up recently. The evidence suggests that it has persistently worked in nearly every financial market in the world, and there is a reasonable expectation that it will continue to work in the future.

In addition, momentum investing might provide effective mission hedging.

Much has been written about how momentum outperforms the market—for more on this, see Asness et al. (2014)4. I will focus on the other claim: why would momentum investing work as a mission hedge?

Suppose you want to hedge against climate change by buying fossil fuel stocks. When more fossil fuels are burned, those stocks gain value and you make more money. So you want to hold fossil fuel stocks when they’re going up. And that’s exactly what momentum does—it buys stocks that are going up.

Of course, ideally, you want to buy stocks before the price starts rising, not after. A momentum investing strategy won’t buy fossil fuel stocks unless they’ve already been going up for a while. So momentum will never work as well as directly mission hedging by buying and holding fossil fuel stocks.

But the basic principle behind mission hedging is that the worse the world gets, the more important it is for you to have money. In the worst worlds for climate change, fossil fuel stocks will likely gain value persistently for long periods of time, which means they will maintain high momentum. If they outperform the market for five years in a row, a momentum strategy will hold them for the last four—80% as good as the direct mission hedging strategy that would have held fossil fuel stocks for all five years.

Momentum fails to mission hedge in worlds where fossil fuel stocks inconsistently outperform the market: for example, perhaps they outperform for a year, then underperform for the following year. A momentum strategy will only hold fossil fuel stocks for the first few months of the second year, during which they’re underperforming. So momentum will both fail to beat the market and fail to mission hedge. But in these worlds, climate change probably isn’t as bad as in the worlds where fossil fuel stocks consistently outperform.

Naturally, the concept of mission hedging via momentum applies to other cause areas as well. For example, the recent rapid progress in AI development has made many people more concerned about AI safety. And at the same time, AI stocks have outperformed the market—as of this writing, the Global X Robotics & Artificial Intelligence ETF (BOTZ) has returned 83% since January 2017, compared to 60% for the S&P 500. Alphabet, Inc. (GOOG), perhaps the leading company in AI development, has returned 92%.5 A momentum strategy would have held AI stocks during most of this period.

In fact, momentum sometimes works as a mission hedge even if you don’t know what you should be hedging. For any type of bad outcome, if there are companies that profit off that outcome, you can expect to make money via momentum investing during the bad times, because you will end up investing in those companies. (This only works if such companies exist, and it requires that you figure out how to spend the money correctly after you earn it.)

Regarding AI, I have seen some people make a slightly different argument: they expect transformative AI to arrive sooner than most people think, so it might make sense to buy stock in AI companies (e.g., deluks917 (2020)). This isn’t exactly the same as mission hedging, but like mission hedging, it involves reducing diversification to take advantage of a particular upside. And like mission hedging, momentum investing might capture that upside without requiring any specific bets about how the future will look. If transformative AI does come soon, then it seems likely (although not guaranteed) that this will be preceded by big developments in AI, and that AI stocks will go up a lot over the preceding 12 months. If that happens, a momentum strategy will end up buying AI stocks in time to capture the benefits of transformative AI.

Whether this works depends on how momentum operates. There are two basic hypotheses as to why momentum investing outperforms: (1) the market under-reacts to good news, or (2) the market exhibits a delayed over-reaction. If hypothesis 2 is correct, then AI stocks likely won’t rise much until it’s too late. But the under-reaction hypothesis appears more likely given the evidence.6 That means if we see evidence that transformative AI is coming soon and AI stocks go up, we will have time to buy the high-momentum AI stocks before transformative AI arrives.

(As of this writing, QMOM, a highly concentrated momentum ETF, holds 4 of the 12 US stocks on deluks917’s list of AI stocks (33%), even though it only holds 5% of US stocks in general. Disclaimer: I hold some shares of QMOM.)

So momentum investing likely beats passive investing both in terms of risk-adjusted return and in terms of mission hedging. But instead of using momentum, should investors directly buy and hold mission hedge stocks? It’s not clear. To answer that, we need to know how much better direct mission hedging works at hedging bad outcomes, and also how much better of a risk-adjusted return to expect from momentum than from direct mission hedging. We don’t know the answers to either of those.

Notes

  1. This is my confidence specifically for the claim that momentum investing is better at mission hedging than the global market portfolio. 

  2. Hillebrandt, H. (2018). A generalized strategy of ‘mission hedging’: investing in ‘evil’ to do more good. 

  3. Fama, E. & French, K. (2008). Dissecting Anomalies. 

  4. Asness, C., Frazzini, A., Israel, R., & Moskowitz, T. (2014). Fact, Fiction and Momentum Investing. 

  5. Total return calculated using https://www.etfreplay.com/charts.aspx on 2020-08-14. 

  6. Barberis, N., Shleifer, A., & Vishny, R. (1998). A Model of Investor Sentiment. Journal of Financial Economics 49 (3): 307-343.