It’s been over twenty years since academics first recognised a momentum effect in the markets, yet it’s only in recent years that momentum investing has really begun to catch on. Momentum, the tendency for relative winning assets to continue winning, whilst relative losers keep losing, has been unfairly maligned and much-misunderstood. However, borne out by academic research and supported by powerful new tools, momentum investing is on the rise. Here’s why:
Academic research validates it
There has been a significant amount of academic research in recent years that has helped demystify momentum and prove its worth as the basis of an investment strategy. In May 2014 Clifford S. Asness, Andrea Frazzini, Ronen Israel (AQR Capital) and Tobias J. Moskowitz (University of Chicago) published ‘Fact, Fiction and Momentum Investing’. This myth busting piece uses academic research and data analysis to show that momentum strategies historically outperform both the market indices and other factors such as value or size, with higher risk adjusted returns. Similarly the 2015 Credit Suisse Yearbook examines industry rotation strategies going back as far as 1900, showing that momentum strategies generated a premium that was bigger even than value.
Buoyed by this research, esteemed firms such as Blackrock, Barclays, Invesco, AQR and MSCI have launched funds and indices which have outperformed the market. These companies lead by example – the more they successfully implement momentum strategies, the more the rest of the market will catch on.
Better models are available
Momentum strategies have a successful track record, however up to now there has been a lack of means of reliably measuring momentum. This has arguably prevented momentum investing from really catching on amongst portfolio managers. The old models and systems are flawed, requiring periods of several months to catch on to trends and thus missing out on profits, or proving erratic in volatile markets.
Momentum models and portfolio analytics have come a long way and there are now accurate and reliable tools on the market that make momentum strategies a more viable option for portfolio managers. The rise of big data means they are more open to using portfolio analytics to improve their performance, either to enhance their existing strategy or to analyse years of data to detect and measure trends and provide an objective outcome.
Smart beta offers cheap exposure to it
Recent years have seen a rise in ‘smart beta’, alternative index strategies that deviate from standard cap-weighted funds by attempting to capture investment factors or market inefficiencies. Smart beta products are increasingly popular and are putting the spotlight on momentum and factor-based investing, for example iShares by BlackRock offers several Momentum Funds and ETFs, including the iShares MSCI USA Momentum Factor ETF.
Smart beta strategies are an attractive prospect to investors as they offer low cost exposure to risk factors such as value or momentum. Investors interested in including momentum in their portfolio can now easily invest in momentum based ETFs, for tax efficient performance without the need to constantly monitor their portfolio.
Markets are becoming less connected to fundamentals
Market trends are becoming more impacted by perceptions and emotions than by the real fundamentals. Luca Paolini, chief strategist at Pictet Asset Management, said to Bloomberg: “There’s a huge disconnect between reality and perception. Europe’s in a bear market when it has quantitative easing, decent valuations, earnings picking up and an improving economy.” This partly explains why a growing population of investors are turning to momentum analysis as the approach that best captures the real underlying price direction. Momentum is a powerful, self-feeding phenomenon and the more people that adopt momentum as part of their decision-making, the stronger and more persistent that momentum becomes. Reluctant investors risk missing the boat.
The basis for investing is trend capturing
The basis for all investing comes down to one thing: capturing trends. A solid assessment of trends should be a ‘must have’ in any strategy. Investors are beginning to realise that as an especially robust and persistent trend, momentum isn’t something that can be ignored.
In an industry under a huge amount of pressure to perform, in just five years, we’ll see more than half of all fund managers incorporate some form of momentum into their investment strategy in order to improve performance, control risk and generate higher returns.
Rocco Pellegrinelli is CEO of Trendrating