Momentum strategies: Knowing when to leave the party

Ever wonder whether momentum investing hurts or helps your portfolio? I believe many investors overlook strong potential return opportunities largely because they are either unaware of the strength inherent in momentum strategies, or they simply have a negative misperception about momentum.

Pioneered in the early 1990s, momentum investing is a trend-following strategy. The goal is to identify what’s “en vogue”, and then exploit that trend. Essentially, you want to get to the party while it’s still in full swing but exit before the energy wanes. At its core, momentum investing presumes that strong performance for a period of time, such as the past 12 months, can signal continued outperformance for a future period, such as the next three to six months.

Momentum investing capitalizes on behavioral biases and the notion that we might not be as rational as we would like to be. One such bias is herding, when we have limited information we have a tendency to go with what is popular or what has outperformed recently. This herding behavior generally leads, in the short term, for stocks that have recently outperformed to continue to do so as people bid up the prices of past winners.  This is the equivalent to what Millennials would call “FOMO” (fear of missing out); the fear that if you miss a party or event you will miss out on something great.1

Momentum is a principle that applies across all stock markets, however, perhaps surprisingly, the success of momentum investing extends beyond stocks. It may be used successfully at the asset class, sector, country, and manager levels. Additionally, momentum strategies may be effective in both bull and bear markets because the same behavioral biases apply, whether the change is upward, downward or sideways.

At Russell Investments, momentum investing is one of our core beliefs, and we often put these strategies to work in our funds. However, we are fully aware that momentum is a fickle friend; it has a good, a bad and an ugly side.

The good: It is relatively easy to identify trends and to gain exposure to the resulting momentum. It can also be a good portfolio diversifier. For example, momentum is negatively correlated to value investing, so the two can be used in tandem. Finally, it is not always highly volatile. Volatility evolves with aggregate investor preferences. For example, in 2007, highly cyclical companies and financial companies saw their prices driven by momentum, creating higher volatility. Following 2008, after the financial crisis, momentum (along with investor preferences) switched to utilities and consumer staples, creating lower volatility.

The bad: Momentum strategies typically result in higher turnover of some investments, so those additional costs must be considered. In a given year, momentum strategies can generate 100% turnover or more within a fund. Additionally, while the standard measure of momentum is relatively straightforward to calculate; separating the signal from the noise can be difficult.  In volatile markets, volatility can easily be confused with momentum. There is definitely risk in this approach.

The ugly: Momentum strategies are prone to severe crashes. While skilled monitoring can help avoid overexposure, by their nature, these crashes are hard to identify. This is where pairing a value strategy with a momentum strategy is likely to help—when one falls the other typically rises. A value discipline is that friend you bring to a party to help steer you out the door before the lights come on and the music stops. In that same vein, value can be the friend that tells you that although it is the trend right now, it might not be the most sensible idea to pay $800 for a pair of jeans that will likely only last one season.

While momentum investing requires monitoring and appropriate diversification, I believe it can be used by most investors if it is viewed realistically within the context of the investor’s goals and combined intelligently with complementary strategies. In other words, when it comes to momentum strategies, party responsibly and bring a rational friend to take you home before the music stops.

1 Source: Urban Dictionary