A View of Momentum Investing

posted on April 15th, 2015 by Bellmont Research Team

This article on momentum investing was written by Nicholas Ooi, a university student who interned at Bellmont Securities during January and February of 2015.

Introduction

For many investors, buying small-cap stocks and value stocks (stocks with prices lower than their intrinsic value) in the hope that they outperform the market, may seem like typical strategies. Historically, these strategies have been documented to exhibit superior risk-adjusted returns on average above market indices, as they seek to exploit the inefficiencies of the market. However, recent studies have shown that abnormal returns or premiums can also derive from another strategy which has only started to become more prominent in the past two decades: momentum investing.

So What Exactly is Momentum Investing?

Momentum investing was first made prevalent by Jegadeesh and Titman in their 1993 paper; ‘Returns to Buying Winners and Selling Losers: Implications for Stock Market Efficiency’. To put it simply, momentum investing involves adopting a long position in securities which have recently shown upward price rises and short selling securities which have recently displayed downward price movements. The theory is based upon the assumption that stocks have a tendency to demonstrate similar past performance for some number of future periods. Essentially, this means that ‘winning’ stocks will keep rising and ‘losing’ stocks will keep falling. In some regards, momentum investing can be like playing a game of hot potato – buying rapidly appreciating stocks, holding them for a relatively short period, then selling them before any unfavourable price changes. ‘Buy high, sell higher’ – sounds like a great plan! But you’re probably asking me, ‘hang on, doesn’t momentum investing contradict traditional investment theory?’ Indeed it does. The approach takes a contrarian view from the fundamental ‘buy low, sell high’ strategy which is often a large proponent of small-cap and value investing. In fact, the momentum theory violates even the weak form of the efficient-market hypothesis, suggesting that markets are not informationally efficient, since investment decisions based on information of past stock performance can generate abnormal returns. This fascinating discovery has led to Eugene Fama, the father of the efficient-market hypothesis, coining the momentum effect as the ‘premier market anomaly’.

Why Does the Momentum Effect Exist?

Many researchers and academics don’t completely understand why the momentum effect exists. There isn’t a generally accepted theory which explains the primary cause of momentum in financial markets. However, there are several key theories which seek to explain this phenomenon, of which two stand out the most. Firstly, many people believe that momentum premiums arise due to risk-based factors. It is assumed that investors who utilise the momentum strategy bear unique risk, as there is a possibility that a volatile market may quickly turn against their favour, and thus they should be compensated for this risk with higher returns. High risk, high rewards – sounds fair. Additionally, research shows that momentum stocks generally have high bid-ask spreads and thus the transactions costs can be quite large. Consequently, the returns from investing in these stocks must be adjusted to account for these large transaction costs. The second, more popular theory, suggests that momentum premiums originate from behavioural biases (or investor behaviour). For example, some investors may have the tendency to sell winning investments prematurely to capitalise on gains, while holding on to losing investments too long in the hope that they would break even. Thus, when good news is announced, prices of stocks do not rise severely due to premature selling. Similarly, when bad news is publicized the prices of stocks fall less sharply as investors are reluctant to sell. This disposition effect can create inefficiencies in the market which can be exploited by rational momentum investors.

Empirical Data in Australia

Momentum investing has proven to be quite successful in Australia, as several quantitative hedge funds and banks have exploited it to reap large profits. Even more so, retail investors are able to tap into this momentum premium, as local portfolio managers (such as Bellmont) are now explicitly implementing momentum as a key part of their investment strategies.

Research conducted by The Super Investor showed that a portfolio of 30 stocks with the highest 12 month relative strengths (a measure of momentum), drawn from the 300 largest companies, generated an average 12 month gain of 15.30% during 1996 to 2009. This portfolio ousted the All Ords index by an amazing 6.44% a year. Thus, if you had invested $10,000 in stocks with high relative strengths for 10 years, your portfolio would have grown to approximately $41,500, which is worth over $18,000 more than if you had invested in the All Ords! Additionally, Bruce Vanstone, an Assistant Professor at Bond University, conducted a series of model simulations to test the effectiveness of equity momentum strategies in comparison with the ASX200. Although past performance is not always the best guarantee of future performance, a simulation nonetheless, can provide some hints as to how a strategy may perform in the future. As shown in the figure below, equity graphs are plotted of a simulated momentum portfolio versus the ASX200 (XJO) index portfolio over the 10 year period from 2000 to 2009. managed accounts matrix Source: Incredible Charts As seen in the figure above, the results from the simulation seem to validate the existence of a momentum effect in the Australian equities market, as the annual percentage rate (APR) of 18.54% for the simulated momentum portfolio significantly outperformed the ASX200 benchmark APR of 4.76%. However, it must be noted that with higher rewards, the momentum portfolio carried much higher risk (-60.07% maximum drawdown) than the ASX200 (-53.15% maximum drawdown).

Implications

Overall, momentum investing is still a relatively new market strategy, but has already been largely endorsed by institutional investors and the academic community. The strategy has proven to be successful within the Australian market, and it is highly foreseeable that investors will continue to research and develop investment methodologies which tap into this premium. Ideally, it would be best if another factor was chosen as the basis for a long-term core investment strategy (e.g. value investing) and use momentum as a short-term ancillary strategy when market conditions are favourable.



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