Most of the main risk factors — value and size, for example — are essentially bets on relatively unloved stocks. But momentum is the exact opposite: it’s a tilt towards the most popular stocks. In other words, compared to other factors, it’s counter-cyclical.
You could also argue that it’s a systematic form of market timing, which we all know can be dangerous.
So, does is tilting towards momentum really a good idea? That’s one of the issues we explore in the latest in this series of videos for Sparrows Capital.
If you missed the first three videos in this series, you can watch them here:
And if you’d like to watch more videos like this, why not subscribe to the Sparrows Capital YouTube channel?
Transcript:
One of the most well-documented asset pricing anomalies is momentum — the tendency of stocks that have outperformed in the recent past to continue outperforming stocks that have recently underperformed over the next several months.
The momentum factor was first identified in 1993 by academics Narasimhan Jegadeesh and Sheridan Titman, who called it relative strength.
Four years later, Mark Carhart included momentum alongside the three original Fama-French factors, in what became known as the four-factor model.
A 2015 study found that the momentum premium was more prevalent than hitherto believed. Christopher Geczy and Mikhail Samonov showed how it applied to different sectors and countries, and also to bonds, commodities and currencies as well as equities.
Why, then, do recent winners tend to outperform recent losers?
Several explanations have been suggested. Some say it’s primarily down to investor behaviour. There’s evidence, for example, that investors under-react to corporate earnings and dividends announcements.
Another possible reason is herding behaviour. Investors who chase returns, the theory goes, provide a feedback mechanism that drives prices further away from fundamentals, causing short-term momentum.
Other experts prefer risk-based explanations. They argue, for instance, that past winners face greater risk going forward, perhaps because their growth prospects have effectively been identified as more risky, which also means they face a a higher cost of capital.
So how has the momentum premium performed over time?
A 2017 paper by Elroy Dimson, Paul Marsh and Mike Staunton showed how, since 1926, a portfolio of winning stocks would have generated returns that were, on average, 7.4% a year higher than a portfolio of losing stocks.
In the UK, since 1900, the difference was even bigger, at 10.2%.
For the ten-year period to the end of April 2021, the MSCI ACWI Momentum Index returned produced an average annualised return of 13.62%. The parent index returned 8.23%.
The March 2020 crash saw a major correction, followed by a substantial rebound for momentum stocks. But then winning stocks underperformed in the first quarter of 2021, partly because of the sudden popularity of so-called meme stocks like GameStop and AMC.
Let’s take a look now at the differences between the MSCI ACWI Momentum Index and the main ACWI index.
The most striking difference is their relative turnover. The momentum index has a turnover of 86.1% since inception, compared to just 3.92% for the parent index. And, of course, higher turnover means higher cost.
The momentum index has a negative exposure to small-cap and value stocks and a very low dividend pay-out.
Here are its top ten constituents in April 2021, compared to the ten biggest stocks in the main index.
You’ll see there’s plenty of crossover, with both lists dominated by large growth stocks.
But the nature of momentum investing means the make-up of the momentum index can change very quickly.
In conclusion, short of radical changes in investor behaviour, the momentum factor is highly likely to persist in the future.
Bear in mind, though, that unlike the other main risk factors, which are essentially bets on relatively unloved stocks, momentum is the exact opposite — it’s a tilt towards the most popular stocks.
In other words, compared to other factors, it’s counter-cyclical.
You could also argue that it’s a systematic form of market timing, which we all know can be dangerous.
So, “handle with care” is the best advice.
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Robin is a journalist and campaigner for positive change in global investing. He runs Regis Media, a niche provider of content marketing for financial advice firms with an evidence-based investment philosophy. He also works as a consultant to other disruptive firms in the investing sector.
