Har­ness­ing the Power of Momentum

by Michael Nairne, Tacita Cap­i­tal

Momen­tum is defined as the ten­dency for invest­ments that have per­formed rel­a­tively well in the recent past to con­tinue to do so and for rel­a­tively poorly per­form­ing invest­ments to con­tinue to fare poorly. It is a well-documented anom­aly in mod­ern finance. Numer­ous aca­d­e­mic stud­ies have con­firmed that, when mea­sured in peri­ods of approx­i­mately three to twelve months, past invest­ment win­ners tend to keep on out­per­form­ing while past losers tend to keep underperforming.

Stocks that evi­dence pos­i­tive momen­tum have returned a sig­nif­i­cant pre­mium to the over­all mar­ket. This pre­mium is illus­trated in the fol­low­ing graph which illus­trates the growth of $1.00 invested in a port­fo­lio of pos­i­tive momen­tum stocks[i] (in dark red) com­pared to the S&P 500 (in light brown) from August 1927 through July 2011.

The $1.00 invest­ment in momen­tum stocks grew to $67,309, nearly thirty times larger than the $2 321 earned in the S&P 500. For long-term investors, this out­per­for­mance has been remark­ably endur­ing. In 99.6% of the ten-year rolling peri­ods since July 1937, momen­tum stocks have out­per­formed the S&P 500. The fol­low­ing graph illus­trates this out­per­for­mance by com­par­ing the rolling 120-month annu­al­ized per­for­mance of momen­tum stocks to the S&P 500 since July 1937.

Momen­tum is not sim­ply a US phe­nom­e­non. A recent study[ii] cov­er­ing equi­ties in 23 coun­tries from Novem­ber 1989 to Sep­tem­ber 2010 found evi­dence of strong momen­tum returns in North Amer­ica, Europe and Asia Pacific; only Japan was an excep­tion. Another study track­ing the largest 100 stocks in the British mar­ket from 1900 to 2009 found that a port­fo­lio com­prised of the 20 best per­form­ers over the prior 12 months out­per­formed the worst per­form­ers by 10.3% annu­ally[iii]. The same authors found momen­tum in 18 out of 19 mar­kets, dat­ing back to 1975 in larger Euro­pean mar­kets and 1926 in the US.

Momen­tum is not con­fined to port­fo­lios of indi­vid­ual stocks – it exists in a vari­ety of asset classes. A recent study[iv] has found that momen­tum exists in gov­ern­ment bonds, com­modi­ties and cur­ren­cies as well as coun­try equity indexes. Momen­tum has also been found in cor­po­rate bonds[v] as well as the finan­cial futures mar­ket[vi].

Behav­ioral finance experts sug­gest that investors’ cog­ni­tive biases are the pri­mary expla­na­tion for momen­tum. Some investors are slow to assim­i­late new infor­ma­tion about a secu­rity and hence, ini­tially under­re­act to good or bad news. This delays the imme­di­ate adjust­ment of prices to fair value. A behav­ioral heuris­tic known as anchor­ing and adjust­ment where indi­vid­u­als rely too heav­ily on their exist­ing view­point and adjust only grad­u­ally to new infor­ma­tion is one fac­tor behind under-reaction. Con­fir­ma­tion bias, the ten­dency to focus on facts that sup­port one’s exist­ing posi­tion, is another con­trib­u­tor to under-reaction.

As new infor­ma­tion is assim­i­lated into the mar­ket and prices begin to respond, the band­wagon effect – the ten­dency to move with the crowd – sets in. Price trends become estab­lished cre­at­ing a momen­tum effect.

Despite its per­va­sive­ness, momentum-based invest­ment strate­gies are far from risk free. For exam­ple, there are pro­longed peri­ods where stocks with pos­i­tive momen­tum under­per­form the mar­ket. This is illus­trated in the fol­low­ing graph which depicts the rolling 36-month annu­al­ized return of the momen­tum pre­mium (i.e. the return of the port­fo­lio of pos­i­tive momen­tum stocks minus stocks of the S&P 500) from August 1930 to July 2011. Despite an over­all annu­al­ized pre­mium of 3.9%, there have 22 peri­ods where stocks with pos­i­tive momen­tum have under­per­formed the mar­ket by greater than 5%, with dura­tions as long as sev­eral years.

Momen­tum is impor­tant phe­nom­e­non that can be exploited by astute man­agers in their pur­suit of supe­rior results for investors. It offers a wide range of appli­ca­tions rang­ing from trad­ing to secu­rity selec­tion. Man­aged futures, in par­tic­u­lar, is a strat­egy that takes advan­tage of momen­tum across a wide vari­ety of assets. As with other factor-based approaches such as value and small cap strate­gies, investor patience is a crit­i­cal ele­ment in suc­cess­fully cap­i­tal­iz­ing on its potential.

Novem­ber 30, 2011

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Tacita Cap­i­tal Inc. (“Tacita”) is a pri­vate, inde­pen­dent fam­ily office and invest­ment coun­selling firm that spe­cial­izes in pro­vid­ing inte­grated wealth advi­sory and port­fo­lio man­age­ment ser­vices to fam­i­lies of afflu­ence. We under­stand the chal­lenges of afflu­ence and apply the lead­ing research and best prac­tices of top finan­cial aca­d­e­mics and indus­try prac­ti­tion­ers in assist­ing our clients reach their goals.

Tacita research has been pre­pared with­out regard to the indi­vid­ual finan­cial cir­cum­stances and objec­tives of per­sons who receive it and is not intended to replace indi­vid­u­ally tai­lored invest­ment advice. The asset classes/securities/instruments/strategies dis­cussed may not be suit­able for all investors and cer­tain investors may not be eli­gi­ble to pur­chase or par­tic­i­pate in some or all of them. The appro­pri­ate­ness of a par­tic­u­lar invest­ment or strat­egy will depend on an investor's indi­vid­ual cir­cum­stances and objec­tives. Tacita rec­om­mends that investors inde­pen­dently eval­u­ate par­tic­u­lar invest­ments and strate­gies, and encour­ages investors to seek the advice of a finan­cial advisor.

Tacita research is pre­pared for infor­ma­tional pur­poses. Nei­ther the infor­ma­tion nor any opin­ion expressed con­sti­tutes a solic­i­ta­tion by Tacita for the pur­chase or sale of any secu­ri­ties or finan­cial prod­ucts. This research is not intended to pro­vide tax, legal, or account­ing advice and read­ers are advised to seek out qual­i­fied pro­fes­sion­als that pro­vide advice on these issues for their indi­vid­ual circumstances.

Tacita research is based on pub­lic infor­ma­tion. Tacita makes every effort to use reli­able, com­pre­hen­sive infor­ma­tion, but we make no rep­re­sen­ta­tion that it is accu­rate or com­plete. We have no oblig­a­tion to inform any par­ties when opin­ions, esti­mates or infor­ma­tion in Tacita research changes.

All invest­ments involve risk includ­ing loss of prin­ci­pal. The value of and income from invest­ments may vary because of changes in inter­est rates or for­eign exchange rates, secu­ri­ties prices or mar­ket indexes, oper­a­tional or finan­cial con­di­tions of com­pa­nies or other fac­tors. There may be time lim­i­ta­tions on the exer­cise of options or other rights in secu­ri­ties trans­ac­tions. Past per­for­mance is not nec­es­sar­ily a guide to future per­for­mance. Esti­mates of future per­for­mance are based on assump­tions that may not be real­ized. Man­age­ment fees and expenses are asso­ci­ated with investing.

[i] The US Momen­tum stock port­fo­lios were con­structed by aver­ag­ing the monthly returns of momen­tum port­fo­lios 8 –10 selected from the 10 port­fo­lios formed on momen­tum avail­able from Pro­fes­sor Ken French’s web­site at http://mba.tuck.dartmouth.edu/pages/faculty/ken.french/data_library.html.

[ii] Fama, E. F. and K. R. French. “Size, value, and momen­tum in inter­na­tional stock returns” (June 21, 2011). CRSP Work­ing Paper. Avail­able at SSRN: http://ssrn.com/abstract=1720139

[iii] “Why New­ton was wrong”, The Econ­o­mist, Jan­u­ary 6, 2011. http://www.economist.com/node/17848665

[iv] Asness, Clif­ford S., Moskowitz, Tobias J. and Ped­er­sen, Lasse Heje, “Value and momen­tum every­where” (March 6, 2009). AFA 2010 Atlanta Meet­ings Paper. Avail­able at SSRN: http://ssrn.com/abstract=1363476

[v] Jos­tova, Ger­gana, Nikolova, Stanislava (Stas), Philipov, Alexan­der and Sta­hel, Christof W.,” Momen­tum in cor­po­rate bond returns”, (Sep­tem­ber 26, 2010). Avail­able at SSRN: http://ssrn.com/abstract=1651853

[vi] Pir­rong, Craig, Momen­tum in Futures Mar­kets (Feb­ru­ary 23, 2005). EFA 2005 Moscow Meet­ings Paper. Avail­able at SSRN: http://ssrn.com/abstract=671841

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