SINGAPORE (Feb 12): Buying a stock for no other reason than because it is rising. Holding on for dear life, hoping to exit with a profit before prices come back down to earth. Sounds reckless? Welcome to the world of momentum investing.
Momentum investing goes against the instincts of most investors (“buy low, sell high”) and replaces it with a dare: “buy high, sell higher”. Despite its seemingly counter-intuitive nature, the potential benefits of momentum investing are well established in academic literature, and could help your portfolio perform better than the market average in the long run.
Momentum works on a simple observation: stocks that are rising in price tend to keep on rising, and those that are falling tend to continue in the same direction. Jegadeesh and Titman established this for the US market in their 1993 paper “Returns to Buying Winners and Selling Losers: Implications for Market Efficiency”. In it, they showed that buying stocks that had been rising for three to 12 months, as well as selling stocks falling over the same time horizon, was a profitable trading strategy over the 1965-to-1989 period. Rowenhorst generalised this to European markets from 1980 to 1995 in his 1998 paper, “International Momentum Strategies”, and many other studies have since confirmed that momentum effects do exist in equity markets in general.
The studies suggest that a portfolio that systematically holds stocks exhibiting positive price momentum should be expected to beat the market average return. The problem is that momentum lasts for only a short time, which means that, in reality, any portfolio trying to take advantage of this effect is going to incur high trading costs, as each component is likely to be switched out within less than a year. Can a momentum strategy be profitable in real life, even after such trading costs are taken into account?
To answer this question, let us consider three momentum exchange-traded funds and compare their performance against that of their standard capitalisation-weighted market benchmarks. MTUM (the iShares Edge MSCI USA Momentum Factor ETF) selects US stocks exhibiting positive price momentum at the 12- and six-month time horizons. As can be seen from the table, over the last three years, MTUM has returned 16.35% a year in the last three years ended December 2017. This represents a significant outperformance over its parent index, the MSCI USA Stock Index, which has returned 11.29% a year over the same period.
Outside of the US stock market, we may consider two ETFs with slightly different takes on a momentum strategy, also shown in Chart 1. IMTM (the iShares Edge MSCI International Momentum Factor ETF) is the international counterpart to MTUM. In 2017, it returned 25.50%, against 24.81% for the MSCI World Ex USA Index — that is to say, it barely outperformed. IMOM (the MomentumShares International Quantitative Momentum ETF) uses a more involved selection process that takes into account not only momentum but also other factors that may indicate whether a stock may outperform. It has returned a whopping 33.16% over the past year, against 25.03% for its benchmark MSCI EAFE Index.
Taken as a whole, these results suggest that it is not inconceivable for momentum investing to outperform in real life net of trading costs. However, one to three years is a very short time frame to judge the success or failure of a particular strategy. Performance also varies significantly across ETFs even if they all purport to trade on momentum, because each provider’s stock selection process is different. Each ETF will perform better at different times, and a “best solution” has not been proven to exist.
In fact, what may not be obvious is that momentum itself tends to be cyclical and should be expected to underperform the market for significant periods of time. This is clear from the chart, which shows the trailing one-year outperformance of MTUM against its benchmark MSCI USA index, since its inception in April 2013 to the present. Data points above the zero line show that MTUM had outperformed its index in the preceding 12 months, and those below the zero line denote underperformance. Since the line spends significant portions of the time below zero, this implies that there are also significant periods of underperformance more than a year long. In particular, if you had invested in MTUM from
Feb 1, 2016 to Feb 1, 2017, you would have been quite disappointed as you trailed the index by about 9% (although if you held on, you would have then made back your money and more in the following months in 2017, which was a great year for momentum in general).
What all this says is that we should be open to having a small exposure to momentum strategies in our portfolio as long as costs are not too high. But we need to diversify and set our expectations correctly. Such an exposure may well do better than the market average, but outperformance will be unpredictable in the short term and only reveal itself over long periods of time. It has to be that way — by definition, it is impossible for everyone to outperform the market average all the time. If you are presented with a strategy that claims to do so, put the momentum into your feet and run away as quickly as you can.
Herbert Lian is a financial adviser at IPP Financial Advisers Pte Ltd. The views expressed here are solely those of the author in his private capacity. This article should not be regarded as professional investment advice or as a recommendation regarding any particular investment.
