Momentum investing has long been a thorn in the side of conventional market theories. That doesn't dim its power as a strategic investment tool, but it can still be an awkward beast.
The momentum approach-investing in stocks that have had high returns in the recent past and dropping those with sluggish returns in the same period to win outsize returns-is difficult to unify with the capital asset pricing model or the efficient market hypothesis. For the moment, it's the financial equivalent of trying to put a round peg in a square hole. But some financial economists are trying anyway, and they may even succeed as they continue to peel away the mystery of asset pricing in the years ahead. But no one will find the process elegant.
In the meantime, there's a list of theories arising to explain why momentum investing works, ranging from traditional risk-premium-based explanations to behavioral economics that study irrational investors.
The concept of momentum investing is compelling not just because investors are hungry for diversification and new strategies but also for it's durability in the real world. Relatively few other strategies survive the transition from paper to real-world portfolios the way momentum investing does.
In the textbooks, minting profits looks easy because the standard asset pricing theory suffers from so-called return anomalies-sources of excess returns above and beyond what's implied by the academic models. But exploiting these anomalies in actual portfolios is hard. Trading costs, taxes and other frictions take a toll. And many profitable return patterns that look solid in the financial laboratory have an annoying habit of disappearing when the crowd comes rushing in.
Is momentum investing different? It appears to be. Academics and money managers tend to agree that it is a resilient source of return that stands up to the usual lines of attack, such as criticism that it's simply a byproduct of data mining or that it's vulnerable to arbitrage. It doesn't hurt that the basic idea is as old as investing itself and so it's stood the test of time.
Since it was formally revived in the academic literature for the first time in the early 1990s, there's been a wide-ranging debate about why momentum investing exists and what it means for modern portfolio theory. Yet now there's a growing acceptance of it as a separate and distinct driver of return premiums. As if to herald this broader acceptance and the strategy's coming of age, the first publicly traded index funds that formally target the strategy were launched last year by AQR Capital Management.
Is it time to consider (or reconsider) momentum as part of a diversified portfolio strategy? The answer would seem to be yes, if the expanding menu of product choices linked to it is any indication.
But the fact that money is chasing the strategy isn't a persuasive argument in and of itself. Momentum investing doesn't offer easy profits or sidestep risk. Indeed, investors seeking out such an approach must be comfortable with who's running the strategy and understand the methodology. In short, the details matter.
A Formal Grasp Of The Obvious
The concept of momentum, generally, is unpretentious. Isaac Newton offered a useful working definition of it in Principia Mathematica more than three centuries ago: A body in motion tends to stay in motion.
As an investment concept, the idea has been around for about as long as organized securities markets have been operating. Momentum-based trading advice dominates the famous 1923 book Reminiscences of a Stock Operator, which says the trend is your friend. And the bull market of the 1960s brought the first wave of momentum-influenced mutual funds, inspired by the trading successes of money manager Gerald Tsai. John Brooks famously chronicled this era in his best seller, The Go-Go Years.
In the modern era, academic research on momentum begins with a 1993 paper in the Journal of Finance by Narasimhan Jegadeesh and Sheridan Titman, who showed how buying stocks that have performed well in the past and selling stocks that have poorly performed in the past can win an investor significant returns over three-to-12-month periods (in their now famous report titled, Returns to Buying Winners and Selling Losers: Implications for Stock Market Efficiency.)
Professors Eugene Fama and Ken French cited the momentum factor as an "embarrassment" for their own popular three-factor asset pricing model, which identifies small and value stocks, along with the overall market, as the primary risk factors driving equity returns. Fama and French couldn't explain the success of momentum investing, even if they did acknowledge its existence.
One researcher, Mark Carhart, a finance professor and former managing director of the quantitative strategies group at Goldman Sachs, took the hint and simply added momentum to Fama and French's three-factor model, coming up with a four-factor approach that he outlined in a 1997 study. Carhart decided that a richer framework for deciphering stock returns would require researchers to look to momentum and place it in the context of value and small-cap effects, along with the broad market beta.
"Momentum is ubiquitous across all major asset classes," says professor Craig Pirrong at the University of Houston, summarizing the conclusion in one of his own research efforts.