Maintaining Momentum: Using Trends to Beat the Market

The momentum effect – the fact that, over time, winning assets will continue winning and vice versa – is gaining in popularity as an investment strategy. Although momentum has not yet been fully embraced in all quarters, this is set to change as investors recognise the potential of this robust and persistent factor.

The FT’s John Authers acknowledges that momentum investing can be profitable but writes that it “feels wrong that money can be made this way.” Momentum doesn’t fully align with conventional wisdom about investment. The “master of the universe” archetype is borne of the notion that capital allocation is a mixture of art and science: a field where perceptive fund managers pick out undervalued stocks and are duly rewarded for their foresight.

To say that winning and losing stocks are destined to keep winning and losing seems too simple, but momentum has a proven track record. According to S&P data, 74% of US equities funds underperformed over the last five years. Fund managers are under pressure to improve discipline, reduce risk and generate returns. When used correctly, momentum strategies are one way to achieve this.

Here are a few reasons why momentum is beginning to catch on now, more than twenty years since its academic discovery:

Fundamental flaws 

“The time to get interested is when no one else is. You can’t buy what is popular and do well.” So says Warren Buffett – the most famous “value investor”, if not the most successful – and many seem to treat it as gospel.

Again, it’s understandable. However fundamentals – earnings, operating profit, economic health etc. – do not always anticipate stock value. “So many other factors can drive returns above or below historical averages”, claims the economist Roger Aliaga-Díaz. Fundamentals may be important, but they don’t provide the whole picture. Europe, for example, boasts a solid (and improving) economy, increased earnings, and quantitative easing – but the market of the moment is still more bearish than bullish.

The momentum effect is reliable. It has been proven to exist in market data going back hundreds of years and its impact will become more pronounced as more fund managers incorporate it into their strategies.

Since Narasimhan Jegadeesh and Sheridan Titman’s seminal 1993 paper there has been a growing amount of academic research supporting momentum, including “A Century of Evidence on Trend-Following Investing” and, more recently, the 2015 Credit Suisse yearbook. This demonstrated that momentum-based industry rotation strategies have generated better returns than even value, going back all the way  to 1900.

This research is being put to practical effect: Institutions such as Barclays and BlackRock have launched momentum funds that are outperforming the market.

Better measurement

The fact that momentum exists does not make it automatically useful to fund managers. Observing the effect and measuring it are two different things.

Older momentum models only rebalance quarterly or biannually, catching onto trends months after the fact and missing out on huge profits. In order to profit from momentum, investors must filter out market noise and bias and overcome the observed industry tendency to sell winning assets too soon and hold on to losers for too long.

However, as momentum analytics become more sophisticated, it’s now possible to act on trends well in advance. Big data has improved the scope, range, and immediacy of information about the markets: portfolio analytics can be used to optimise performance – and suggest ways to capitalise on trends.

Momentum & Smart beta

Smart beta strategies offer investors a cheaper, tax-efficient and systematic way of increasing their exposure to momentum. Active management is expensive and, as the evidence shows, may not yield the expected returns. Traditional passive management is cheaper but without the possibility of above market returns. Smart beta on the other hand aims to outperform the benchmarks by tracking alternative index strategies that weight assets according to factors such as momentum. As a strategy, it is neither entirely active nor entirely passive: it lies somewhere in the middle, and prizes rationality and transparency.

Heavyweights such as Blackrock’s iShares, the world’s largest ETF provider, have issued market beating momentum based smart beta products such as iShares MSCI USA Momentum Factor ETF. Other ETFs include momentum as part of a multi-factor strategy. Goldman Sachs’ competitively priced ActiveBeta ETFs acquires stocks based on a combination of factors including momentum, value, quality and low volatility

Staying on-trend

Trend analysis isn’t very romantic. It’s hardly the Gordon Gekko approach to investment, and the very mention of the word “momentum” is probably enough to make Warren Buffett break out in hives. But Buffett-style portfolios built on fundamentals are already faltering; if you doubt this, ask the man himself.

In an industry where performance is king, investors are beginning to realise that purely value-driven strategies are outmoded. In five years, my strong suspicion is that a majority of fund managers will treat momentum as a significant element in their decision process.

It might not make them masters of the universe – but they will see better returns.

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