Relative Strength: How Does Momentum Investing Work?

In Brief

An investing strategy of buying prior winning stocks and selling short prior losers based on the empirical observation that Investments exhibit persistence in their relative performance. As George Chestnutt wrote back in 1965: “Which is the best policy?  To buy a strong stock that is leading the advance or to "shop around" for a "sleeper" or "behind-the-market" stock in the hope that it will catch up?  . … Many more times than not, it is better to buy the  leaders and leave the laggards alone.  In the market, as in many other  phases of life, "the strong get stronger, and the weak get weaker."

Background

Buying winners inherently conflicts with the contrarian philosophy that is part and parcel of many successful investors. Nevertheless, it has long been noted by traders that good performing investments tend to continue to do so, whereas those that have performed relatively poorly tend to continue on the same path.

Momentum investing is not to be confused with growth investing, short-term price acceleration, or general trend following. It usually involves a disciplined, systematic investing style based on relative price strength over a specific (usually 6 to 12 months) formation period combined with systematic entry and exit rules. 

Definition of a Relative Strength Screen

Richard Driehaus is an example of an investor with a heavy momentum bias, blending earnings and price momentum. However, an indicative 'pure momentum' screen might be: 

• Exclude the most illiquid stocks, e.g. the bottom 25% of stocks based on market capitalisation
• High relative strength in the last six months compared with the market (top 25%) - relative strength doesn't work over short timeframes, such as one month.
• High relative strength in the previous twelve months compared with the market (top 25%), with the 12 months being higher than the three months
• The hold period for investments would typically also be in the 3-12 month range.

Adding value and/or earnings momentum criteria usually increases the screen effectiveness (see below).

Interestingly, this study  showed that individual investors tend to be relatively bad at applying momentum investing strategies effectively, as against professional investors.

How Well Does it Work?

Academics have focused on studying momentum investing properly for the better part of two decades. A study by Hancock found a momentum strategy outperformed a broad universe of U.S. stocks by nearly 4% per year from 1927-2009.

Likewise, the AQR Momentum Index showed a 10 year CAGR of 13.7% (18.6% volatility) vs. 11.2% for the Rusell 1000 Index (15.7% volatility). Some research suggests that momentum investing delivers even better abnormal performance than either size or value styles. Momentum’s effect exists in nearly all sizes/sectors, different asset classes and international markets. It does however depend on the investment time horizon. Most academic studies of momentum skip the most recent month, since “there exists a reversal or contrarian effect in returns which may be related to liquidity or microstructure issues” (Jegadeesh). Overall, trading based on individual stock momentum appears to be a poor strategy over a short historical horizon (especially less than one month); it is highly profitable at intermediate horizons (up to 24 months, but especially in the 6- to 12-month range); and is once again a poor strategy at long horizons (beyond 24 months).

Research has shown that momentum is particularly beneficial when combined with a value style because the two are negatively correlated. Moskowitz and Grinblatt conclude that “A value-momentum combination mitigates the extreme negative return episodes a value investor will face (e.g., the tech boom of the late 1990s and early 2000 or a dismal year like 2008)”. Research also indicates that momentum can be a catalyst to value, i.e. the research suggests that value stocks that have been long-term losers but have high 6–12 month returns will go on to outperform by an even wider margin.

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Why does it work?

Research is ongoing but the most likely explanation is that momentum is a phenomenon driven by investor behavior and the "bandwagon” effect. Following the Nobel prize-winning work of Daniel Kahneman and Amos Tversky, several possible behavioral explanations have been put forth:

i) Slow reaction to new information. Different investors receive news from different sources and react to news over different time horizons and in different ways, creating an “anchoring and adjustment” effect whereby in which individuals update their views only partially when faced with new information, slowly accepting its full significance.

ii) Asymmetric responses to winning and losing investments. Investors tend to sell winning investments prematurely to lock in gains and hold on to losing investments too long in the hope of breaking even. The disposition effect creates an artificial headwind, i.e. when good news is announced, the price of an asset does not immediately rise to its true value because of premature selling or lack of buying. 

Interestingly, research by Scowcroft and Sefton found that,  when it comes to large-cap stocks, price momentum is largely driven by the momentum of a stock's broader industry sector and not by the momentum of the individual stock itself. 

Watch Out For

Like any strategy, momentum does not deliver positive returns all the time. Research by Hancock found that the strategy suffered during periods of high stock market volatility and that the strategy had poor relative performance in the six months following recent bull market tops and bear market bottoms. He also came to the conclusions that "volatility is bad for momentum, largely because volatility is associated with mean reversion and not trending".  See also more recent work covering the 2009/09 period by Kent Daniel of Columbia Business School. 

It also has a more volatile return profile - even though the AQR Momentum Index had a 22% higher return than the Russell 1000 index during the ten year period discusssed above, it also had 18% more volatility. As it's an investment strategy with a relative short time horizon, the trading costs of momentum investing are higher than those of value and growth, but they are reportedly not high enough to materially change the attractiveness of momentum (Israel and Moskowitz 2010, not yet published).

From the Source: 

Jegadeesh and Titman’s 1993 paper “Returns to Buying Winners and Selling Losers: Implications for Stock Market Efficiency” generally get the credit for “discovering” the momentum effect in academic circles. Their work showed that simple relative strength strategies that rank stocks based on their past 3-12 month returns predicted relative performance over the next 3-12 months.

Other Sources:

There are now over 300 momentum papers published in academic journals.  For a brief review of some of the prominent research papers, see AQR Capital Management’s Annotated Bibliography of Selected Momentum Research Papers. See also:

• Momentum Investing  - Finally Accessible for Individual Investors
• Momentum – A Contrarian Case for Following the Herd
• Value and Momentum Everywhere
• The Case for Momentum Investing
• 3 Ways Momentum Investing can Harm Your Portfolio
• Optimal Momentum: A Global Cross Asset Approach
• AQR Momentum Indices
• International Momentum Strategies