Momentum investing as opposed to growth investing is a strategy of buying financial assets that are showing strength and selling those which are showing weakness. It is based on the simple idea that securities that have performed well relative to peers (winners) on average continue to outperform. On the other hand, stocks which have performed poorly in the past would continue to do so.
A momentum stock would typically have the following characteristics:
Rising trend; Institutional ownership; history of making explosive moves; low share float; do not pay dividends; have favourable upcoming catalysts (eg:FDA approval; new product launch; beating earnings estimates); gaining media attention!
Investors buy/sell them for short term gains rather than “buy and hold”. Thus, timing is key!
In the empirical paper “ Frog In the Pan: Continuous information and momentum” by Zhi Da, Umit G. Gurun ,Mitch Warachka (2014) an analogy is made with the reaction of a frog put in a pan and momentum strategy:
If the water is boiling, it will immediately jump out.
If the water is gradually warmer, it won’t notice the gradual change in temperature and will cook.
FIP suggests that investors act in a similar way with regards to changes in stock price.
This can be linked to investors limited attention idea and disposition effect discussed in "prospect theory: an analysis of decisions under risk" (Kahneman & Tversky,1979).
The boiling frog metaphor can
in a sense be compare to the Hare (momentum) and the Tortoise (growth) fable-->
FIP paper hypothesis:“a series of frequent gradual changes attracts less attention than infrequent dramatic changes. Investors therefore underreact to continuous information.”
Results: “Over a six-month period, momentum increased from –2.07% in the discrete information portfolio to 5.94% in the continuous information portfolio, even after the authors adjusted for risk. Investors seem to underreact to continuous information (information discreteness and momentum).
Moreover, despite inducing stronger short-term return continuous information is not associated with long-term return reversals. This lack of return reversal is constant with limited attention causing investors to underreact to continuous information”.
Conclusion: A more sophisticated momentum strategy that focuses on the path-dependency of momentum generates a much stronger momentum effect. The paper also suggests that investors have limited attention.
A well executed momentum strategy requires perfect entry and exit. In “Causes and Seasonality of Momentum Profits” (2007) Richard Sias found that With Januaries (a month in which lagged "losers" typically outperform lagged "winners") excluded, the average monthly return to a momentum strategy for U.S. stocks was found to be 59 bps (0.59%) for non-quarter-ending months but 310 bps (3.1%) for quarter-ending months-
This is because some institutional and individual
investors may avoid selling winners in December to
prevent recognising taxable gains.
As a result, tax-motivated selling of losers and resistance to selling winners may
contribute to return momentum in December.
This simple tax based strategy is used
by most sophisticated retail investors whereas institutional investors will window-dress
their portfolio to embellish the fund's portfolio
Therefore suggesting a better performance of momentum strategy in
December and quarter ending
months (figure 1&2).
Momentum investing has received much critique in the past by value and growth investors as it opposes the popular saying “time in the market beats timing the market". It requires an actively managed portfolio and unlike fundamental or value investors, momentum investors are not concerned with a company’s operational performance. Some suggest that momentum investors are leveraging the behavioural weaknesses of other investors, such as the tendency to “follow the herd”. Hence it may feel wrong to speculate on short term “hype” helping a market inefficiency grow even worse.
In 2014 C.Asness, A.Frazzini, R.Israel, T.Moskowitz rectified the myths on momentum investing through facts in “Fact, Fiction, and Momentum Investing”
Myth 1) momentum returns are too small and sporadic.
Myth 2) momentum cannot be captured by long-only investors because momentum can be exploited only on the short side.
Myth 3) momentum is much stronger among small-cap stocks than large caps.
Myth 4) momentum does not survive, or is seriously limited by, trading costs.
Myth 5) momentum does not work for a taxable investor.
Myth 6) momentum is best used with screens rather than as a direct factor.
Myth 7) one should be particularly worried about momentum’s returns disappearing.
Myth 8) momentum is too volatile to rely on.
Myth 9) different measures of momentum can give different results over a given period.
Myth 10) there is no theory behind momentum.
Those arguments in favor of momentum investing have gained popularity among both retail and institutional investors and tend to be used in high volatility market environments (^VIX) especially in emerging markets discussed in "Using volatility to enhance momentum strategies" .
Retail investors tend to use a momentum or trend following strategy. Thus buying more salient (attention-catching stocks) than institutional investors. This was discussed by B.Barber and T.Odean (2008) in "All That Glitters: The Effect of Attention and News on the Buying Behavior of Individual and Institutional Investors" who predicted that:
Individual/retail investors are net buyers of attention-catching stocks
Institutional investors are net sellers of attention-catching stocks
Price pressure (upward) in attention-catching stocks (Da, Engelberg, Gao,2013)
Stocks (sorted into deciles of salience) with high volume tend to go in the portfolio
of retail investors from institutions. On the other hand when
volume is low it tends to go from retail investors to institutions (Figure 3).
<--
Retail investors buy
stocks that had both high positive and negative returns the previous day (Figure 4)-->
Therefore it is important for retail investors to assess the
quality/impact of a news on a stock. This can be assessed using a Bayesian illustration (Figure 5)-->
An easy momentum strategy can be made by analyising changing demographic shifts overtime or forecasting the increase/decrease demand for a certain good or service. Long term momentum plays are also seen in disruptive technology stocks which break up existing market structures and dictate completely new ground rules to an industry or the market as a whole. The article “Disruptive Technologies: Catching the Wave” (1995) by Joseph L.Bower and Clayton M. Christensen helps better assess and spot such innovation (figure 6).
Momentum in a stock can also be caused by a ripple effect in economically linked stocks. In “Economic links and predictable returns” (2008) Cohen and Frazzini concluded that:
1 -Investors appear to be inattentive to customer-supplier links.
2 -Supplier returns are predictable using customer shocks.
3 -Zero-investment (long-short) portfolio earns 15-18 percent per year.
4 -Information diffusion takes about 1 year!
Disclaimer: This strategy does not generate excess returns anymore.It does however when using customer information that is less easily available than stock returns.
Timing a momentum strategy is key, it is preferable to use the following indicators to assess the entry and exit of the Momentum strategy: Moving averages - Trend lines -The Average Directional Index (ADX) - Stochastic oscillator
Other behavioural factors such as disposition effect and loss aversion will affect the closure of a momentum trade. It is Important to rationally assess those factors in order to efficiently use a momentum strategy!
Momentum ETF’s:
iShares MSCI USA Momentum Factor ETF (MTUM); Fidelity Momentum Factor ETF (FDMO); SPDR Russell 1000 Momentum Focus ETF (ONEO); Invesco DWA Momentum ETF (PDP)
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