This quote from Eugene Fama, joint winner of the Nobel Prize for Economics in 2013 and a strong believer in efficient markets, highlights just how important momentum can be for investors.
The approach (also known as trend following) is an investment strategy that uses historic returns to predict future returns. The crucial assumption of momentum investing is that market movements are driven by longer trends and that last period’s winners will continue to outperform last period’s losers.
Who uses a momentum strategy?
When talking about momentum, some people may think about the systematic momentum strategies applied narrowly by specialist hedge funds. However, many investors unknowingly follow a momentum strategy by accident. Shares and markets that have gone up (or down) often get additional news coverage.
Being at the centre of media attention may then induce more buyers (or sellers). In addition, momentum changes the composition of market-cap weighted indices: shares that have rallied become a bigger part of an index and the same applies for equity regions that have performed well within a global index. Why might momentum trading work?
In an efficient market, where the market price captures all available information (and historic returns are readily available publicly), a systematic momentum trade should not work. However, in reality there is support for momentum not just from practitioners, but from a number of independent studies. Indeed, academic research has found evidence of momentum effects both within and between financial indices in equities, fixed income, currencies, commodities and the multi-asset context.
Some supporters of momentum argue that markets tend to go through (excessive) swings around their fair value, driven by the irrationality and herd behaviour of investors. Clearly, momentum cannot persist into perpetuity. As behavioural effects continue to drive prices away from fair value, valuation pressures start to dominate. Eventually, the trend breaks, the market reverses and – as this reversal gains pace – may eventually overshoot in the opposite direction. In this cyclical model, investors have to time the cycle if they want to make money from momentum – they need to be smarter than the rest of the ‘herd’ and to identify the turning points (when valuations become too extreme).
The more rational explanation for the momentum trade says that the market does not fully and immediately price in new information. Some investors continue to stick to an ‘old’ estimate of fair value and only gradually change their minds. This slow adjustment of prices towards their new, fair value shows up as momentum. A number of reasons may explain the inertia: imperfect information may mean it takes some time until news filters down to retail investors; some investors may be overconfident in their price estimate and unwilling to accept news; or they just stick to their purchase price (unwilling to realise a loss). The ‘fast-money’ investors will make a profit as they price in the news first, but a pure momentum trader can also hop on the same trade and benefit from the slow price adjustment. ‘Slow’ traders that stick to the wrong price are losing out.
While the general concept may sound easy, momentum can be difficult to implement in practice. “The trend is your friend …until the bend in the end”. To make a momentum strategy work, timing is crucial – the trend may just be about to turn or the new information has already been fully priced in, leaving no further upside.
From a quantitative perspective, trading rules are optimised through back testing. For a momentum indicator, we can look at daily, monthly, or annual data; returns may also be risk-adjusted and sometimes it ‘works’ to use lagged data and other medium. The second element is to choose the investment strategy – for example, deciding when momentum is strong enough to take a position, how positions are sized, and how frequently positions are adjusted. The performance of a momentum trade depends heavily on the above choices and it can be very difficult to identify the right implementation rule.
Looking at different types of investors, professional investors with dedicated resources should be the most likely to benefit from momentum effects while those retail investors that are trading to chase a trend or trade based on their limited and sometimes outdated information are more likely to lose out. But there are downsides even for the smartest momentum traders.
First of all, costs. Momentum is a trading strategy and, like all trading strategies, it creates costs – commissions, fees, bid-ask spreads and so on. Especially for the shorter term momentum trades, looking at intra-day, daily, or weekly trends, and for momentum in individual stocks, the costs will often exceed the benefits and make a momentum trade unprofitable.
Second, implementing a fully-fledged momentum strategy usually requires short-selling and leverage. When used for return generation, both are often a recipe for failure. At the least, they make it much more complex and expensive to manage a portfolio.
Last, momentum is often – almost by definition – a crowded trade. Despite the complexity of the trading rules that specialist managers may come up with and their secrecy to protect these, there is often little differentiation in the positioning of ‘smart’ managers. In August 2007, quant-equity managers were caught up in a sudden liquidity freeze, and when they tried to unwind their positions, it became clear that all held quite similar allocations: as they all tried to run for the exit at the same time, prices collapsed and caused huge losses and fund failures.
For an investor, it is important not to rely solely on a single investment style. Momentum can be an important indicator, which can be used to identify and flag up potential opportunities that can then be analysed in a thorough way. It sometimes makes sense to position oneself alongside recent market momentum, sometimes against it. There is no hard and fast rule.
For example, Japanese equities started to perform well in late 2012, driven by a fundamental change in policy from the government and central bank. The new policy framework provided a fundamental case that supported ongoing market momentum into 2014.
As a counter example, emerging market equities strongly underperformed the developed world in 2013, driven by credit concerns in China and a variety of local conflicts (Ukraine/Russia, Turkey and Thailand, for example). Relative underperformance came on top of meagre returns for the past couple of years.
Developed markets have therefore become increasingly expensive and a significant amount of negative news is priced into emerging markets.
More systematically, momentum also relates to rebalancing, which has gained in importance in a post-RDR world where portfolios have to be aligned to a client’s attitude to risk to have continued suitability. Rebalancing sells out of asset classes that rallied and rebuilds exposure to those that have fallen. This is clearly the opposite of momentum trading, but in its systematic implementation it has been shown to add consistent returns through “selling high and buying low”.
Evidence of momentum in financial assets challenges the idea that the market always knows best. At the same time, adopting a momentum-based strategy is harder than it sounds. Chasing returns is not enough and will likely just result in paying higher transaction costs. In an active asset allocation approach, being aware of market momentum has to be part of a balanced assessment, but the fundamental investment proposition (and an understanding of the risks) should always be paramount.
Martin Dietz is a fund manager of Legal& General Investment Management
Key Points
Many investors unknowingly follow a momentum strategy by accident
For a momentum indicator, we can look at daily, monthly, or annual data
Despite the complexity of the trading rules that specialist managers may come up with and their secrecy to protect these
