What is it? Where does it come from? And how to apply it in today’s markets?
“Trend is your friend” – Martin Zweig
If you invest in the markets, you have probably heard this quote before. It has to do with an investment strategy called Momentum.
The word Momentum is commonly used in everyday life. For example, in sports, a team has momentum when it is on a winning streak and it seems almost impossible to stop it. In physics, the definition of momentum is the tendency of an object to keep moving in the same direction unless an outside force makes it deviate from its trajectory.
In finance, the momentum effect implies that stocks that performed well in the past during a given period will continue to do well in the same period in the future. The same principle applies to stocks that performed badly in the past and are expected to underperform in the future.
Momentum Investing is, therefore, a strategy that consists of buying stocks that outperformed in the past and selling stocks that underperformed in the past.
Research Shows Strong Evidence of Momentum Effect in Financial Markets
Jegadeesh and Titman (1993) were the first to show evidence that momentum in finance exists. They documented that a trading strategy “which buys stocks that have performed well in the past and sells stocks that have performed poorly in the past generate significant positive returns over 3–12-month holding periods.” Over the period of time studied, it delivered significant excess returns.
Other researchers later demonstrated the robustness of the momentum theory and found that a momentum long-only strategy also consistently delivered positive alpha (without necessarily doing short selling), and that Momentum Investing can be applied to other asset classes such as bonds, commodities or currencies.
Momentum Effect Is a Consequence of Investors’ Behavioural Biases
“Under the tenets of behavioral finance, markets are not always efficient. It is human behavior that moves markets and not the universal information shared by market participants.” ― Gary Antonacci
Even though there is no consensus in academic research, Momentum is a market anomaly that can be explained by several reasons. The Herd Instinct is one of them and refers to a phenomenon in which investors imitate the actions of others. Momentum also comes from investors overestimating their own information and underestimating others’ ability to obtain and act on the same information, or from investors underreacting to information and holding to their losers. This topic remains an open field in the academic world.
Momentum Investing in Today’s Market
“One market paradigm that I take exception to is: Buy low and sell high. I believe far more money is made by buying high and selling at even higher prices.” ― Richard Driehaus
Richard Driehaus is considered the “father of Momentum Investing.”. He notably developed a successful strategy of buying stocks in upward trajectories and sticking with them to get the rewards through applying the momentum effect.
Driehaus was a trailblazer for the momentum strategy and it is now commonly used in the asset management industry to provide investors with exposure to this factor. Portfolio management techniques or pure momentum financial products are available today to add value for investors.
Capturing Trends and Momentum Indexes
Momentum Investing is about capturing trends and it is highlighted by the evolution of the MSCI USA Momentum Index. This index aims to provide exposure to the Momentum factor by tracking stocks with high price momentum.
During the COVID-19 pandemic period, the MSCI USA Momentum overweighted growth technology stocks as well as healthcare and biotechnology sectors, allowing investors to capture the upside trend in these stocks generating alpha with +29.6% in 2020 vs. +18.4% for the S&P 500. In the current market driven by inflationary pressures and higher interest rates, the index has more exposure in the financial sector and value stocks as compared to 2020 showing how the application of the momentum factor can lead to trend following.
Risks and Limits Specific to Momentum Investing
Any investment strategies carry risks. Regarding Momentum, when only invested in stocks, momentum strategies tend to be more volatile and exhibit higher drawdowns than broader market equity capitalisation-weighted indexes. Besides, Momentum strategies may underperform when the market is moving sideways with no clear trend directions. It is also associated with a high turnover ratio compared to buy-and-hold passive strategies.
ETFs To Incorporate Multi-Asset Momentum Strategies
As Momentum Investing notions can be extended to asset classes other than stocks, ETFs can be great tools to develop multi-asset strategies based on Momentum. ETFs’ Rotation Strategies that invest in ETFs based on Relative Strength (measure of price momentum) can provide exposure to different asset classes (stocks, bonds, commodities), regions or sectors through momentum. Mixing different asset classes in these kinds of portfolios allows for diversification and can help to reduce volatility and drawdowns while getting excess return provided by the momentum effect over time.
Summary
Momentum is definitely a unique and interesting factor to build investment strategies around. Today’s market offers a wide range of possibilities to implement Momentum in investors’ portfolios to better diversify and capture trends, with ETFs, indexes or Popular Investors’ strategies. Momentum Investing can help navigate a world of uncertainty with many unknowns.
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