In this article, we will provide an overview on momentum investing, explaining what the strategy is and how it works. We will provide historical values that shows that strategy generated positive returns in the past but also negative returns if the most recent period is observed.
What is it?
In the previous article (Low Volatility Investing – Smart Beta’s Gem) about Smart Beta we examined what it is and analysed the key drivers of one of its most profitable strategies, the low volatility funds. It is only logical to further pursue our analysis and look at a maybe lesser known strategy: momentum investing.
Momentum investing is a strategy of buying stocks or other securities that have had high returns over the past three to twelve months, hoping that the upward trend will continue, whilst at the same selling the underperforming stocks of the benchmark. Momentum investing is a bit the opposite of minimum volatility investing: the idea is to gain from capital appreciation from short to medium term upward fluctuations, when the price rises above its fundamental value. As soon as the stock starts plunging, approaching its “accurate” valuation, the fund manager liquidates the asset, theoretically making a profit.
Does it work? Why?
Momentum investing is in direct contradiction with the first rule of efficient markets: future prices are independent from previous fluctuations. In theory, it should not perform, but in fact it has proved profitable, at least through most of history. Historic US stock returns show that the momentum strategy gained 8.3 per cent per year from 1927 to 2013, compared with the 7.9 per cent by which stocks as a whole outperformed cash, and the 4.7 per cent by which cheap stocks beat expensive ones. This advantage persists even when these returns are adjusted for risk.
Explanations about why the strategy works vary. The most prominent ones rely on classical behavioural economics: investors are either overconfident or over attached to stocks, failing to sell them at the right moment, which gives the window of opportunity for this strategy to work. But it may also be the case that because of the same rationale, the strategy may prove unprofitable.
Since July of this year however, as we can see on the graph below, the strategy has given negative results. The reason is that since the beginning of the year most of the positive momentum stocks, such as utilities and consumer staples are coincidentally minimum volatility as well. What happened is that when the minimum volatility ETFs started underperforming at the beginning of the third quarter, the momentum funds followed them. It has been the worst quarter for momentum since 2009.