Why aren’t more of us simple momentum investors? I ask because in the last five years my no-thought momentum portfolio has more than doubled, which means it has out performed all but one unit trust in Trustnet’s database of all companies funds – the exception being Chelverton’s UK equity growth fund.
Most, funds, therefore, have missed a very simple trick. Why?
It’s not because they didn’t know about the success of momentum strategies. The fact that past winners continue to beat the market was first pointed out for US stocks back in 1993 by Narasimhan Jegadeesh and Sheridan Titman in the Journal of Finance, the leading journal of financial economics. Since then, economists have found that momentum works in European markets; in Asian ones (other than Japan); in Victorian England; in 19th century America; in commodities; and in currencies. “The existence of momentum is a well-established empirical fact” wrote AQR Capital Management’s Clifford Asness in 2014.
Every professional investor should therefore have known five years ago that momentum investing had been a good idea. But the fact that almost all of them have underperformed the most simple-minded implementation of it shows that most did not become momentum investors. Why not?
True, large funds cannot hold as few as the 20 stocks which my momentum portfolio holds. But Jegadeesh and Titman showed that momentum works if you take the 10 per cent of stocks that have risen the most, and that outperformance is robust to different measures of momentum, such as returns in the last three, six, or 12 months. That gives a momentum investor dozens of shares to pick from. And while my portfolio requires plenty of trades at the end of each quarter to replace shares that have dropped out of the top 20 past risers, a portfolio with more stocks could easily trade less. You could run a momentum portfolio with perhaps only two or three trades a month.
Momentum investing is, therefore, feasible at reasonable dealing costs.
Instead, there are other reasons not to be a momentum investor. One has been pointed out by Victoria Dobrynskaya at Moscow’s National Research University. It’s that momentum stocks sometimes underperform falling markets. In the first three months of last year, for example – when Covid-19 devastated global markets – my momentum portfolio fell even more than the FTSE 350. It also underperformed during other bad times for the market, such as at the end of 2018 and during the worst phase of the 2008-09 financial crisis.
This is a nasty risk. But investors have been well rewarded for taking it. In the last 15 years, for example, my momentum portfolio has outperformed the FTSE 350 by 11 percentage points a year. That’s a humungous risk premium.
Paradoxically, though, this – especially when allied to the sheer weight of evidence that momentum works – is actually a reason not to have been a momentum investor.
One likely reason for momentum’s success is that investors undereact. They stick to their opinion that a stock is a dud in the face of new evidence to the contrary. This means they don’t immediate respond as fully as they should to good news, with the result that share prices which rise after such news drift up further in the following weeks as the news sinks in.
But put yourself in the shoes of somebody who knew all this (say) five years ago and who looks at a momentum portfolio like mine at the time. You might reasonably think: “Yes, momentum’s done well for years. But investors must have cottoned onto this by now and wised up to their error of under-reacting”. And you’d have good evidence for such scepticism. You might reasonably have looked at the very fact that momentum stocks had done well recently and thought “such big price rises show that investors have bought into momentum investing, and in doing so they’ve bid prices up so far that future returns will be poor.”
What’s more, you’ll also have had a good precedent for such concerns. In the late 1980s there was abundant evidence that small stocks had outperformed large ones. But by then investors had twigged this fact, and pushed up the prices of such stocks so far that they subsequently under-performed for a decade.
In stock picking, the sheer weight of evidence for a strategy is a reason for not pursuing it – because the stronger the evidence, the greater the chance that it is already in the price. At almost any time in the last ten years, a sensible investor might reasonably have feared that momentum had become priced in and therefore played out.
If these are good reasons to have missed out on momentum stocks, there is however a bad one. Some investors want to think that stock-picking is a test of ability. They don’t believe that it can be as simple as reading old economics papers and using a stock screen. Instead, they invent clever-sounding reasons and complicated strategies, few of which add any value other than boosting their own ego and persuading gullible clients that they know what they’re doing. But as Warren Buffett has said, the key to successful investing is not intelligence but discipline – the strength to stick to a good strategy.
The truth is, though, that in recent years a mediocre economist with a few minutes work has outperformed almost all fund managers. The latter should therefore hope that investors have now wised up to momentum investing and thus killed it off.