Momentum

While some investors like Warren Buffet believe in looking for quality stocks, we have known that stocks with the highest momentum over the medium term tend to outperform the market.

Termed momentum investing, this approach has been studied a lot since Narasimhan Jegadeesh and Sheridan Titman first published their findings in the Journal of Finance in 1993.

What is momentum investing?

Momentum investing is an approach that seeks to buy stocks with the best historical performance over a given period and then periodically rebalance the portfolio such that at any given time, it’s invested in the stocks with the highest momentum.

This approach is based on the momentum hypothesis, which believes that there is a strong correlation between 3-12 months ‘historical return and 3-12 months’ future return.

That is, stocks that performed the best over the medium term (3-12 months) are likely to continue performing well in the near future, say the next 3-12 months.

How momentum investing works

Here’s how it works:

• A momentum investor buys stocks that have performed best over the last 6 months (can be 3, 9, or 12 months)
• The investor rebalances his portfolio every month or 3 months by selling the least performing ones and buying new stocks that are currently performing better.

Research findings

Since 1993 when Narasimhan Jegadeesh and Sheridan Titman found a strong correlation between 3-12 months ‘historical return and 3-12 months’ future return, many studies have been done on the momentum hypothesis.

In one of the studies, Alpha Architect analyzed stocks in the top 40% of the largest stocks on NYSE based on market value from 1974 to January 2016.

They measured the return on each stock over the past 12 months and rebalanced the portfolio each month by investing in the top 10% stocks with the best price performance.

They deducted 1% annually for transaction costs and another 1% for the annual management fee. Their findings showed an annual return of 14.4% against a 10.92% annual return for the S&P 500.

Similarly, ValueSignals tested the momentum hypothesis on 1,500 European stocks from 1999 to 2011.

They grouped them into small-cap, mid-cap, and large-cap categories and found the relative strength of each stock based on price performance over the past six months: stocks with the best performance over the last six months were placed in the Q1 column, the next set in Q2, and continued down to Q5 for stocks with the worst performance over that period.

Here’s a table showing the total return over the entire period:

	Q1	Q2	Q3	Q4	Q5
Small-cap	285,8%	196,2%	1,0%	-42,9%	-90,3%
Mid-cap	248%	167,2%	85,1%	35,3%	-80,2%
Large-cap	150,6%	137,6%	97,2%	60,6%	-18,1%

From the table, you can see that stocks in the Q1 column had the best returns over that period. When they used a 12-month historical performance as a basis for the ranking, here’s what they found:

	Q1	Q2	Q3	Q4	Q5
Small-cap	224,9%	168,2%	8,2%	-49,4%	-83,4%
Mid-cap	159,6%	173,6%	98,7%	28,7%	-50,6%
Large-cap	152,7%	116,3%	75,9%	100,0%	-11,4%

 

In a master’s thesis, Quantitative Momentum in the Nordic Markets, Felipe Pasquotto de Andrade and Lars Iver Strand studied the momentum hypothesis in Norway, Sweden, Denmark, and Finland.

They created two portfolios: Generic Momentum Strategy (GMS) based on the research of Jegadeesh and Titman, the first two researchers to write about the momentum effect, and Quantitative Momentum Strategy (QMS) based on Alpha Architect’s analysis of qualitative momentum.

In line with Alpha Architect’s findings, these master’s students found that a quantitative assessment of momentum (QMS) gives better results than GMS regardless of the assessment rebalancing periods.

However, the only strategy that consistently managed excess returns in Norway, Denmark, Sweden, and the entire Nordic region was 12 months assessment period and 3 months rebalancing period.

The portfolio with equities from all over the Nordic region managed an annual excess return of 5.6% compared to the MSCI Nordic Index, and this was also found to be statistically significant. Interestingly, the higher return was achieved with lower price variations and a lower maximum unrealized loss.

The chart below shows the result for QMS using a 12-month assessment period and a 3-month rebalancing period:

Source: https://brage.bibsys.no/xmlui/bitstream/handle/11250/2579283/2030734.pdf?sequence=1&isAllowed=y

As you can see, due to the effect of compounding, the excess return made a huge difference over a period of 20 years.

Conclusion  

Although momentum can be profitable, it involves frequent rebalancing, and as such, there may be large trading costs from brokerage commissions and spreads.