Momentum: “The Trend Is Your Friend”
Can you gain from jumping on to the gravy train? Sure, but it’s not for the faint-hearted and expect some bumps along the way.
Factor investing has gained a lot of popularity in the past few years. In essence, factors are attributes that are likely to influence investment returns; for example, the low volatility factor may outperform the market by focusing on low risk assets, while the quality factor may generate a steady return but you won’t win big.
The momentum factor is the phenomenon where stocks that have been rising in price may continue with this trend and keep rising. It is typically expressed by purchasing assets that have performed well in the past with the belief that the strong performance will persist.
Like the value factor, academics have studied momentum extensively, most notably by Narasimhan Jegadeesh and Sheridan Titman in their seminal paper, “Returns to Buying Winners and Selling Losers”. In 1997, Mark Carhart1 added momentum to the original Fama-French model creating the “Carhart Four-Factor Model”. In the past decade, Kent Daniel at Columbia Business School has further validated the pervasiveness of momentum across asset classes.2
Why Does Momentum Exist?
Investors may have a delayed reaction to good news such as better than expected earnings, causing the share price to rise slowly but then pick up the pace as more and more investors become aware of the positive earnings and news. Investors’ over-confidence and self-belief may also lead to high returns in the short term.3 By and large, momentum is a product of investors’ behavioral biases.
On the opposite end, investors may also overreact to bad news (e.g. very poor results) and keep selling a stock which compounds the downward momentum.
Sometimes, momentum is generated by a good story/narrative, as in the case of Beyond Meat, a breakout startup with a captivating story about producing plant-based meat alternatives. Its “feel good” narrative was that we can save the planet and improve our health by reducing meat consumption without compromising our taste buds. On May 2, 2019 Beyond Meat marked its debut on Nasdaq with an impressive opening at $46, a huge surge from its listing price of $25. The company quickly became talk of the town, with its products being featured in restaurants big and small. In July 2019, its share price reached a peak of $239.
Despite the company’s warning that it may never turn a profit, investors focused on Beyond Meat’s immense growth potential. The narrative completely captured investors’ attention; and as more of them bought in, they helped build a momentum which further fueled the company’s share price. A year on, Beyond Meat’s share price has been choppy with some significant drops, highlighting the bumpy nature of the momentum factor.
How Is Momentum Measured?
Momentum metrics usually examine the price performance of the asset over the last three, six and 12 months. With stocks, the price performance in the last month is removed as there are frequent stock price reversals over one month. With corporate bonds, the excess return of the six-month period can be used. Many factor indices are available as ETFs and they typically use some of these metrics to select underlying assets with momentum characteristics.
Should We Invest In Momentum?
At The Index Standard, we advocate using momentum in the context of a wider, more balanced portfolio. If investors can stomach the risk, momentum can be a desirable complement to value.4
Other Factors
Visit The Index Standard Guides for information on other popular investment factors.
References
- Carhart, M. M. (1997). "On Persistence in Mutual Fund Performance". The Journal of Finance.
- Momentum Crashes, Kent D. Daniel, Columbia Business School. Tobias J. Moskowitz, Yale University, 24 Dec 2013
- Scientific Beta. “Adding Value with Factors” Noel Amenc, Patrick Bielstein and Felix Goltz. December 2018
- Value and Momentum Everywhere, AQR, Client Asnes, Tobias Moskowitz, Lasse Perdersen, 2013