Ten Myths About Momentum Investing, Squashed by Tim du Toit, Quant Investing

If you think share price momentum (also called Price Index) is something only traders use and is of no interest to long-term investors (including value investors) then you will definitely find this article of value.

In May 2014 Clifford Asness, Andrea Frazzini, Ronen Israel , (all from ARQ Capital Management) and Tobias Moskowitz from the University of Chicago published a very interesting paper called Fact, Fiction and Momentum Investing.

Momentum 20 years old

The paper clarifies, using already published research studies, the myths that have developed around the concept of momentum since it was first written about in 1993, more than 20 years ago.

What is momentum?

Momentum  is  the  observation  that  share prices which  have  performed  well  (increased more)  relative  to  other share prices (peers) on  average  continue  to outperform,  and  that prices  that  have  performed  relatively poorly (decreased more) tend to continue to underperform.

The word relative is crucial as momentum is calculated by ranking a company’s share price movement against other companies.

For example if you look at 12 months momentum the share with highest (or best) momentum is the one with the largest share price increase over 12 months.

How is it calculated?

In the screener we calculate momentum or Price Index (PI) as (current share price / share price 12 months ago). This allows you to easily and quickly sort companies by share price momentum.

The screener has momentum (or price index) available on all companies from 1 to 60 months for you to use when looking for investment ideas.

Momentum is not trend following

Momentum is often confused with trend following. But trend following is something completely different as shown in the following table.

Momentum Investing

Source: Fact, Fiction and Momentum Investing

Momentum: History, Data and Methodology

Momentum has been a viable investment strategy for:

  • US equities for more than 212 years (data since 1802).
  • It has also been shown to work in 40 other countries
  • More than a dozen other asset classes like bonds, currencies, commodities and others.

Myths about Momentum Investing

Myth no. 1: Momentum returns are small and sporadic

To see if this myth is true, the authors compared it to the following investment strategies:

  • RMRF: Equity Risk Premium or the aggregate equity returns minus the risk free rate. This is the percentage the stock market outperformed cash.
  • SMB: (Small minus Big portfolio) buy small stocks and sell large stocks, – capture the size effect.
  • HML: (High minus Low portfolio) buy high book-to-price (same as low price to book) stocks and sell low book-to-price stocks, represents value.
  • UMD: (Up Minus Down portfolio) buy stocks that have high relative one year performance and sell stocks that have low relative one year performance, captures momentum.

The table below shows the return of size, value and momentum strategies. It also shows the Sharpe ratios, a ratio that calculates the performance of an investment by adjusting for its risk.

When comparing the return of different investment strategies the one with a higher Sharpe ratio gives you a better risk adjusted return.

Momentum Investing

Source: Fact, Fiction and Momentum Investing

Across all three time periods, momentum (UMD) outperformed value (HML) and size (SMB) strategies. Momentum does have higher volatility, but if you look at the risk adjusted returns (Sharpe Ratios), momentum was still the best strategy.

Momentum is not sporadic

The table below shows you if returns from momentum investing are sporadic or not. The table shows the percentage of times each strategy generates positive returns (i.e., the longs beat the shorts, so for value this is how often the cheap stocks beat the expensive stocks, for momentum it’s how often winners beat losers)

Momentum Investing

Source: Fact, Fiction and Momentum Investing

Momentum best

Over the 36 year period (1927-1963), of you look at 1 year rolling period, momentum is the most consistent, with positive returns 81% of the time as opposed to value, with positive returns 63% of the times.

If you look at 5 year rolling periods over the 36 year period (1927-1963), value (HML) does slightly better than momentum (UMD). In the other time periods, 1963-2013 and 1991-2013, momentum is as good if not better than value and size strategies.
As you can see returns using a momentum investment strategy are not sporadic.

Value and momentum an even better combination

If value and momentum each on their own can give you market beating returns what happens if you combine value and momentum.

The paper also tested a combined value and momentum strategy with the following results:

Momentum Investing

Source: Fact, Fiction and Momentum Investing

You can clearly see that the combined portfolio (60% value 40% momentum) produces the highest percentage of positive returns, in both 1 year and 5 year periods with the best risk adjusted return (highest Sharpe ratio).

Myth no.2: Momentum cannot be used by long-only investors as it is a strategy that can only be used by short investors

This myth that momentum can only be help you if you are a short seller just refuses to die, especially amongst value investors.

The paper looked at this and came up with the table below which shows the returns from investing long and short using in a momentum strategy.

Momentum Investing

Source: Fact, Fiction and Momentum Investing

As you can see long momentum has returned slightly more than short momentum strategies over long periods of time.

Thus the assertion of momentum only being “short strategy” is simply not true.

Myth no.3: Momentum returns are much larger for small caps than large caps

The table below compares the returns of momentum (UMD) and value (HML) strategies applied to small and large companies.

Momentum Investing

Source: Fact, Fiction and Momentum Investing

As you can see momentum returns from large companies are substantial even if they are slightly less than for small companies.

The larger returns for small companies can be due to of higher risk, inefficiencies (information availability) or simply because of larger price movements (volatility).

This is no different than the difference in returns from a value strategy (right part of table). And small companies also returned slightly more than large companies so you can hardly say that small company momentum returns are a lot different.

Myth no. 4: Momentum does not survive or is seriously limited by trading costs

There is no ignoring the fact that momentum is a high turnover strategy (our testing has found six months rebalancing best) compared to other strategies like value investing where you may hold an investments for years.

However the authors used data from AQR Capital, a large institutional investor, to show that for a large institutional investor, the average trading costs for momentum strategies are quite low.

This unfortunately does not help you as a small investor. One way you can overcome the problem is to invest in a fund that use momentum strategies.

Myth no. 5: Momentum does not work for taxable investor

In the paper the authors found that momentum, despite having 5-6 times the turnover of value investing for example, had a similar tax burden if you are a USA tax payer.

This is because: