As a concept, momentum investing is simple: buy (overweight) assets that have recently outperformed their peers and sell (underweight) those that have underperformed.
Milan Vidojevic, senior quantitative researcher at Robeco, argues that despite the relative simplicity of this investment approach, it has been able to generate strong long-term performance in equity markets.
He points to the 10-year returns of various factors since the 1930s and the fact that momentum has delivered the highest gross returns in five out of nine decades and has beat the market in all nine.
In a research paper Fact, Fiction and Momentum Investing, Clifford Asness founder and principle of AQR Capital Management claims value investors have consistently attempted to discredit momentum that it is too ‘small and sporadic’ a factor, which works mostly on the short-side, only among small stocks and doesn’t survive trading costs.
He says momentum is a risky variable factor (as they all are) and echoes the view of Vidjevic that there is an impressive long-term average return that survives all the attacks (and myths) hurled against it.
Vidojevic believes behavioural finance goes a long way in explaining the existence and continuing pull of the momentum factor.
“Unlike in mainstream, neoclassical finance, where investors are considered to be ‘rational’ agents that understand risks and opportunities in financial markets, behavioural finance builds on the assumption that investors are not fully rational and they make decisions based on heuristics, which can lead to mistakes and therefore anomalies.”
He adds that the overconfidence investors have in their ability to analyse securities, and tendency to attribute success to skill and failure to bad luck, can help explain the existence of momentum.
For instance, if positive news-flow emerges that affirms the views of private investors, they will tend to push the stock price of the related company above its fundamental value. This is eventually rectified when fresh news-flow highlights the overreaction, typically leading to a long-term correction in the stock price.
Underreaction can also contribute to a momentum premium. This is based on the conservatism bias that implies investors tend to change their beliefs slowly.
“In this scenario, Vidojevic explains, “the bias would restrain a firm’s stock price from initially adjusting adequately in response to news-flow. But this underreaction can instigate momentum as the price moves slowly towards its correct (fundamental) value, due to the good news being taken into account progressively.”
If momentum-linked anomalies have delivered robust returns on the back of mistakes in human reasoning, the natural question is why have they not been arbitraged away?
Vidojevic believes there are a number of reasons. “Firstly, momentum is not an easy factor to harvest. Unlike value, for instance, which can be implemented with a modest turnover of 10-20% per year, the traditional momentum factor typically has a turnover of a several hundred percentage points a year. Clearly, in order to effectively harvest this factor after costs, one needs to apply smart trading strategies.”
He adds that while the momentum premium has been linked to behavioural biases as opposed to risk, exploiting it may not be completely painless. Momentum strategies have been prone to rare but severe crashes. Therefore, momentum investors also need to be able to commit their capital over a longer-term period and be ready to face challenging times.
The fact there is there is no one correct way to define momentum is a consideration too.
“Even simple price momentum is often defined using different lookback periods, ranging from three to 12 months. Also, an investor can choose to implement one version of momentum or to combine multiple factors such as residual momentum or connected analyst momentum.”
Lastly, Vidojevic suggests that human psychology and a propensity to make cognitive mistakes should not be underestimated. “Much of the experimental work in finance shows that humans consistently make errors, even when they have been previously informed of them.”
He concludes: “One does not need to dig deep to find examples of over-extrapolative markets, fuelled by human enthusiasm. Time and time again, these patterns emerge and lead to predictable patterns that only systematic and patient investors may be able to exploit.”