Momentum investing

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. It assumes that the price trend will continue.

There are two main flavors of momentum investing. The first flavor can be seen as being part of technical analysis: traders use momentum indicators to interpret buy or sell signals.

The second flavor is an investing strategy that attempts to exploit the momentum factor, or momentum anomaly, discovered by academic research. For example, Jegadeesh and Titman (1993) construct "relative strength" portfolios where the stocks that have performed the best (the bottom decile stocks or 'winners') over the previous 3-12 months are purchased, and those that performed the worse (the top decile stocks or 'loosers') are sold (by short selling them). These positions are then held for 3-12 months. The authors found that this strategy produced "significant abnormal returns over the 1965 to 1989 period".

This article is concerned with the second flavor of momentum investing, as implemented for example in some ETFs available in Canada and the US.

Background
Carhart (1997), building on the Fama-French three factor model, added a forth factor, the one-year momentum anomaly of Jegadeesh and Titman (1993) , to explain the cross-section in returns of equity mutual funds in the US from 1962 to 1993. This four factor model is now known as the Fama-French-Carhart model.

There are two groups of explanations for the momentum anomaly/factor. The first group of explanations proposes that extra returns are accounted for by extra risk. The second group consist of behavioral explanations such as "investor underreaction and delayed overreaction to news".

In The 52-Week High and Momentum Investing, Thomas J. George and Chuan-Yang Hwang state that: There is substantial evidence that stock prices do not follow random walks and that returns are predictable. Jegadeesh and Titman (1993) show that stock returns exhibit momentum behavior at intermediate horizons. A self-financing strategy that buys the top 10% and sells the bottom 10% of stocks ranked by returns during the past 6 months, and holds the positions for 6 months, produces profits of 1% per month. Moskowitz and Grinblatt (1999) argue that momentum in individual stock returns is driven by momentum in industry returns. DeBondt and Thaler (1985), Lee and Swaminathan (2000), and Jegadeesh and Titman (2001) document long-term reversals in stock returns. Stocks that perform poorly in the past perform better over the next 3 to 5 years than stocks that perform well in the past.

Issues
Many momentum strategies involve short selling. Note that short selling, if employed, "exposes investors to unlimited downside risk by short selling uncovered positions in their portfolios".

Most momentum strategies have high turnover, high trading costs, and in taxable accounts may result in the investor paying more taxes.

Larry Swedroe notes that research on momentum is conclusive, but that the "publication of academic research can impact the performance of investment factors shown to have premiums".

Rick Ferri writes that "Momentum can add value through better trading to an existing portfolio that is following some other strategy. However, trying to capture this factor as a stand alone premium is extremely difficult due to costs".