It seems that momentum has been in the news of late. In this case we are not discussing recent market moves, but rather the use of momentum as a factor in portfolio construction. For example, Morningstar recently announced that they will begin including momentum as an explanatory factor in their fund and stock reports.
Indeed some view this as overdue recognition of momentum (or relative strength) strategies. There is no shortage of research in the momentum factor. Over at CXO Advisory there is an extensive list of research summaries of momentum in its various forms. Even though the momentum effect has been recognized for some time there are two challenges facing momentum still outstanding.
The first is that there is no single, universal definition of momentum. In academia, the most common definition of momentum for common stocks is the twelve month return excluding the most recent month. This happens to be the approach used by AQR Funds in the management of their suite of momentum index funds. However nearly every academic paper on momentum uses multiple formulations of momentum.
James Picerno writing at Financial Advisor has an article up looking at this history of momentum in the academic literature and its use today as an alternative beta. Picerno notes why momentum is so interesting to investors:
The concept of momentum investing is compelling not just because investors are hungry for diversification and new strategies but also for it’s durability in the real world. Relatively few other strategies survive the transition from paper to real-world portfolios the way momentum investing does.
The second issue is that there is no single explanation of why momentum works. Most formal attempts to explain momentum utilize recent findings in behavioral finance. A common explanation being that investors under react to news thereby spreading out any subsequent price effect over time. Indeed recent research indicates that the momentum effect is in fact an echo momentum effect. A quick review of the literature shows no dearth of explanations for momentum.
Maybe this ambiguity in definition and causation is in fact the strength of momentum investing. An interesting post up at Systematic Relative Strength walks through the history of momentum and finds that momentum is endemic to financial markets, including the equity markets. They write:
Relative strength is part of the DNA of markets. Markets and asset classes everywhere exhibit momentum. Relative strength is universal and so malleable that it can be used to power stock selection or global tactical asset allocation. Relative strength makes no assumptions about the future–it simply adapts to what is. Darwin wrote, “It is not the strongest of the species that survives, nor the most intelligent, but rather the one most adaptable to change.” Relative strength is adaptive and adaptation is what ensures survival.
If we take the literature at face value we can include momentum alongside other market factors as an ‘alternative beta.’ With the market gearing up to exploit momentum as factor the question is whether it will continue to maintain its relative performance. James Picerno again:
As for experimenting with new risk factors in public funds, we’ve been here before. In the early 1980s, for instance, there was hope for the newly recognized power of the small-cap premium. In the following decade, small-cap value earned an academic blessing. In both cases, new products arrived soon after to exploit these academically sanctioned ideas. As a general proposition, both have worked out well, albeit with varying results.
It is not clear that any investor should live by momentum alone. Even the most ardent of momentum investors at Systematic Relative Strength notes that momentum-like strategies could best be used as a complement to other more placid strategies like: value strategies or even balanced strategies. However in all cases they note the importance of a disciplined approach to each of these approaches.
All that being said, momentum remains a paradox. Momentum is easily calculated and widely disseminated. It is hard to believe that momentum strategies would continue to outperform in that sort of environment. However, to-date they have. So much so, that academia and practitioners alike recognize it as a return factor.
Will this momentum era end at some point? Maybe. The construction of momentum indices might lead to its eventual demise. In the meantime investors of all stripes need to take note of momentum in designing their approach to the markets.