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.

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:

1. Sensible
2. Persistent across time periods
3. Pervasive across markets
4. Robust in the data
5. 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

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.

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.