Momentum investing is a system of buying stocks or other securities that have had high returns over the past three to twelve months, and selling those that have had poor returns over the same period.
While no consensus exists about the validity of this strategy, economists have trouble reconciling this phenomenon, using the efficient-market hypothesis. Two main hypotheses have been submitted to explain the effect in terms of an efficient market. In the first, it is assumed that momentum investors bear significant risk for assuming this strategy, and, therefore, the high returns are a compensation for the risk. Momentum strategies often involve disproportionately trading in stocks with high bid-ask spreads and so it is important to take transactions costs into account when evaluating momentum profitability. The second theory assumes that momentum investors are exploiting behavioral shortcomings in other investors, such as investor herding, investor over- and underreaction, disposition effects and confirmation bias.
Seasonal or calendar effects may help to explain some of the reason for success in the momentum investing strategy. If a stock has performed poorly for months leading up to the end of the year, investors may decide to sell their holdings for tax purposes causing for example the January effect. Increased supply of shares in the market drive its price down, causing others to sell. Once the reason for tax selling is eliminated, the stock’s price tends to recover.
Richard Driehaus is sometimes considered the father of momentum investing but the strategy can be traced back before Donchian. The strategy takes exception with the old stock market adage of buying low and selling high. According to Driehaus, “far more money is made buying high and selling at even higher prices.”
In the late 2000s, as computer and networking speeds increase each year, there were many sub-variants of momentum investing being deployed in the markets by computer driven models. Some of these operate on a very small time scale, such as high-frequency trading, which often execute dozens or even hundreds of trades per second.
Although this is a reemergence of an investing style that was prevalent in the 1990s, ETFs for this style began trading in 2015.
Performance of momentum strategies
In a study in 1993 Narasimhan Jegadeesh and Sheridan Titman reported that this strategy give average returns of 1% per month for the following 3–12 months. This finding has been confirmed by many other academic studies, some even going back to the 19th century.
Turnover tend to be high for momentum strategies, which could reduce the net returns of a momentum strategy. Some even claim that transaction costs wipe out momentum profits. In their 2014 study ‘fact, fiction, and momentum investing’ Cliff Asness and his co-authors address 10 issues with regards to momentum investing, including transaction costs.
The performance of momentum comes with occasional large crashes. For example, in 2009, momentum experienced a crash of -73.42% in three months. This downside risk of momentum can be reduced with a so called ‘residual momentum’ strategy in which only the stock specific part of momentum is used.
A momentum strategy can also be applied across industries and across markets.
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Ofer Abarbanel is a 25 year securities lending broker and expert who has advised many Israeli regulators, among them the Israel Tax Authority, with respect to stock loans, repurchase agreements and credit derivatives. Founder of TBIL.co STATX Fund.