Next wave: Yes, momentum investing can be rewarding

New research says the risks are predictable and manageable

For the uninitiated, momentum investing seems counter-intuitive – and perhaps a little scary given that it shakes up traditional notions of share trading.

Whereas mainstream value investors typically buy stocks at a discount and wait for them to appreciate (following the Wall Street edict of buying low and selling high), the momentum methodology is all about buying high and selling higher or, alternatively, cutting your losses with under-performing assets.

In their paper, Momentum Has Its Moments, Pedro Barroso, a senior lecturer in the school of banking and finance at UNSW Business School, and Pedro Santa-Clara, the chair in finance at Nova School of Business and Economics in Portugal, note that this form of trading has historically offered investors the highest Sharpe ratio – a measure for calculating risk-adjusted returns that has become an industry standard.

"However, momentum has also had the worst crashes, making the strategy unappealing to investors who dislike negative skewness and kurtosis," Barroso and Santa-Clara write, referring to events such as the 1932 market collapse and the global financial crisis (GFC) in 2008.

The authors add, though, that risks associated with momentum investing are quite predictable and that "managing this risk virtually eliminates crashes and nearly doubles the Sharpe ratio of the momentum strategy".

Barroso says academics have long debated whether it is profitable to invest in momentum given that it appears to violate logical market expectations.

"But there is a consensus empirically that it exists in many asset classes – in equities and currencies and commodities," he says. "So it is an empirical phenomenon, though it's theoretically challenging to explain why it exists."

Barroso and Santa-Clara note that from 1927 to 2011, momentum had monthly risk-adjusted returns of 1.75% in stock markets, but that the "remarkable performance of momentum [also] comes with occasional large crashes".

"In 1932, the winners-minus-losers strategy delivered a -91.59% return in just two months," they write. "In 2009, momentum experienced a crash of -73.42% in three months. Even the large returns of momentum do not compensate an investor with reasonable risk aversion for these sudden crashes that take decades to recover from."

‘The big advantage of our methodology is to show that there is a pattern of predictable risk that is there quite constantly, even among the best of times, for momentum’


 Strong performance

Momentum investing received considerable attention courtesy of a 1993 paper, Returns to Buying Winners and Selling Losers: Implications for Stock Market Efficiency, by Narasimhan Jegadeesh and Sheridan Titman from the Anderson Graduate School of Management at University of California, Los Angeles.

Their paper found that strategies "which buy stocks that have performed well in the past and sell stocks that have performed poorly in the past generate significant positive returns over three to 12-month holding periods".

In effect, momentum leads to a scenario whereby investors ride 'hot' stocks and sell 'cold' ones.

Barroso says one of the key points is that while market crashes are generally impossible to foresee, momentum crashes "seem to be more predictable than the market-wide phenomenon".

"So this predictability could be used by investors to pursue their strategies and scale down their exposure before the crashes. That's an empirical result," he says.

Barroso and Santa-Clara also propose an improvement on momentum investing strategies that may suit some, but not all, investors. The authors found that if they scaled exposure to momentum – using the realised variance of daily returns over the previous six months – the risk-managed momentum strategy achieved a higher cumulative return with less risk.

While the most important benefit is a reduction in crash risk, managing risk through scaled momentum also improves the Sharpe ratio in the months without crashes.

"The big advantage of our methodology [is] to show that there is a pattern of predictable risk that is there quite constantly, even among the best of times, for momentum," Barroso says. "So it improves on momentum even when momentum works well, not only when it works badly."

‘You need to be able to say this stock is a dog and I’m going to get it out of my portfolio'


 Relative and absolute

Nick Radge, head of trading and research at stock market advisory service The Chartist, is an advocate of momentum investing and uses it as the core of his trading strategy.

"At the end of the day, momentum is pretty well what I am all about," he says.

However, Radge stipulates it is important to distinguish between 'relative' and 'absolute' momentum, with the combination of the two acting as a risk-management strategy. ?

Relative momentum considers the price strength of stocks with respect to other assets, with rankings based on gains. As such, stocks are compared with each other on a relative basis, exposing them to downsides such as the Black Monday crash in 1987 and the GFC.

Absolute momentum, on the other hand, considers an asset's own positive excess return over a given time period. Such assets are always "sailing with the wind", Radge says, and not only have to be the strongest in the market but also have positive momentum for a year or more.

Under the combined methodology, if a stock is negative for 12 months it "falls off the perch and we get rid of them and over time we will go to cash and wait for the upside momentum to occur".

Using this system, Radge says his portfolio dropped about 13% in 2008-09 as a result of the GFC, compared with up to 45% for many financial planners and brokers.

"That is because we use a form of absolute momentum," he explains. "In other words, the stock has to be showing itself to be going up or showing a positive return for the period of time, whereas with relative momentum there is no rule that the stock has to be going up or down – it just has to be going down at a slower rate than something else."

Far from accepting that momentum investing fares badly in crashes, Radge says that after the GFC many investors realised that a number of value-driven investors "really had no downside concept whatsoever". He adds that finance guru Warren Buffett, a value investor, lost billions of dollars in the GFC.

"So why isolate momentum as something that's inferior to anything else?"?

According to Radge, a quantified approach to momentum investing using historical data makes sense.

"That gives our clients a degree of comfort that they're trading or investing in a strategy that they actually know works, as opposed to taking the advice of a financial planner or a stockbroker when you're relying on the skill of the individual rather than the mathematics behind it."

 Numbers game

Despite significant literature on the success of momentum investing, Radge says misconceptions remain that it is dependent on market timing, when it is not.

He argues that such a strategy is easy to understand – even if it requires expertise to execute – and that it is a sound methodology for mum-and-dad investors.

"You need to be able to say this stock is a dog and I'm going to get it out of my portfolio," he says. "That becomes very difficult for people who anchor themselves and have some kind of a buy price to try to get their money back."

Radge is confident momentum investing will become increasingly popular within academe and the investment community.

"It will take some time to become mainstream, but it's on its way. The numbers don't lie," he says.

Barroso and Santa-Clara conclude that unconditional momentum "has a distribution that is far from normal, with huge crash risk". However, they reaffirm that the risk of momentum is highly predictable and managing this risk eliminates exposure to crashes and substantially increases the Sharpe ratio of the strategy.

Noting that the results of his paper with Santa-Clara are based on international evidence and robust subsamples, Barroso says their findings that risk is predictable through momentum investing will be "provocative" in some circles.

"That makes the puzzle even deeper and bigger and more interesting."


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