Momentum investing fad or bona fide factor
Momentum strategies have gained favor with some factor investors in recent years, particularly during periods when the stock market trended strongly higher. Momentum strategies are based on the idea that stocks that have been steadily rising may continue to do so, and that falling stocks—with negative momentum—may continue to decline. The question remains, though, whether stock price changes alone represent a meaningful factor that’s a sound basis for investment.
Among exchange-traded funds (ETFs), there are over 40 single-factor ETFs that use momentum, with assets of over $15 billion.¹
Momentum investing has its roots in a research paper that found investors could have generated attractive returns by buying stocks exhibiting positive momentum in the past and selling poor-performing stocks over holding periods of 3 to 12 months.² In other words, the research offered evidence to suggest it was possible to reliably ride recent stock price trends.
From that point, momentum began to be considered by some to be a factor, or an objective characteristic, of stock market behavior that has historically delivered a performance premium over longer periods. Other factors documented by academic research include size, value, and profitability.
However, it’s fair to say that momentum is one of the more controversial factors. For example, some struggle to make a solid fundamental case why companies with stocks that have been rising should continue to do so. Perhaps more important, it’s difficult to capture the momentum premium in a cost-effective manner because consistently buying winners and selling losers implies significant portfolio turnover.³ This, in turn, results in trading and market impact costs and taxes that can negate any performance premium that may have been present.
Hindsight is 20/20: backtested versus real world performance
With so much market data and computing power available today, it’s much easier for investors to look backward for characteristics that have outperformed the broader market, but implementing these strategies in the real world and successfully capturing the premiums is usually much more difficult.
Dimensional Fund Advisors, the subadvisor for the John Hancock Multifactor ETF suite, believes that a true factor of expected return must be:
- Persistent across time periods
- Pervasive across markets
- Robust in the data
- Cost-effective to capture in well-diversified portfolios⁴
Point 1 raises some potential issues, as it’s difficult to come up with sensible fundamental or economic reasons for why momentum exists, which leads to questions over whether momentum premiums will persist in the future. Momentum is particularly problematic for point 5, because capturing it requires a lot of portfolio turnover and trading costs.⁴
Sector tilts and other risks
Investors should be aware that so-called momentum indexes can carry significant sector biases that can quickly change based on market conditions. For example, the MSCI USA Momentum Index had nearly 40% in the information technology sector at the end of August 2019, compared with about 22% for the S&P 500 Index.⁵
Momentum also tends to be a particularly volatile factor in terms of performance. Not surprisingly, it often performs well when the market’s in a stable uptrend; however, momentum stocks often fall harder than the overall market during sharp sell-offs. Put another way, momentum investing works—until it doesn’t.
Momentum as a trading screen
Although momentum doesn’t pass some of Dimensional’s requirements as a factor for expected returns, the firm does consider momentum during implementation.
Specifically, with stocks it already owns in portfolios, Dimensional may hold off on selling a stock exhibiting positive momentum. Conversely, it may delay buying a stock that’s showing negative momentum, as it may get cheaper, and thereby potentially avoid a “value trap.” This may allow investors to capture the historical premiums of momentum, but in a cost-effective, low-turnover manner without incurring direct costs for the portfolio.
The momentum factor has exhibited historical outperformance, but it’s sporadic and difficult to capture efficiently. However, if it’s used thoughtfully to implement a portfolio, momentum can potentially boost returns.
1 “A Global Guide to Strategic-Beta Exchange-Traded Products—2019,” Morningstar, 3/21/19. 2 “Returns to Buying Winners and Selling Losers: Implications for Stock Market Efficiency,” Journal of Finance, March 1993. 3 “Have Investors Benefited from Momentum Strategies?” Dimensional Fund Advisors, 7/11/18. 4 “From Premium to Dimension: Raising the Bar on Research,” Dimensional Fund Advisors, 6/6/13. 5 MSCI USA Momentum Index fact sheet, as of 8/30/19, msci.com; S&P 500 Index fact sheet, as of 8/30/19, us.spindices.com.
The MSCI USA Momentum Index tracks the performance of stocks displaying momentum characteristics. The S&P 500 Index tracks the performance of 500 of the largest publicly traded companies in the United States. Diversification does not guarantee a profit or eliminate the risk of a loss. It is not possible to invest directly in an index. Past performance does not guarantee future results.
John Hancock ETFs are distributed by Foreside Fund Services, LLC in the United States, and are subadvised by Dimensional Fund Advisors LP in all markets.. Foreside is not affiliated with John Hancock Investment Management Distributors LLC or Dimensional Fund Advisors LP.
John Hancock Multifactor ETF shares are bought and sold through exchange trading at market price (not NAV), and are not individually redeemed from the fund. Shares may trade at a premium or discount to their NAV in the secondary market. Brokerage commissions will reduce returns.
Dimensional Fund Advisors LP receives compensation from John Hancock in connection with licensing rights to the John Hancock Dimensional indexes. Dimensional Fund Advisors LP does not sponsor, endorse or sell, and makes no representation as to the advisability of investing in, John Hancock Multifactor ETFs.