“The premier anomaly is momentum.”[1], so said Eugene Fama, author of the efficient market hypothesis, seminal academic researcher on momentum investing and 2014 co-recipient of the Nobel Prize in Economics. Evidence has shown that momentum strategies that exploit this anomaly can be applied to generate excess returns for investor portfolios.

Momentum strategies are centered on the observation that market participants display initial under reactions and lagged overreactions to changing market dynamics. This behavioral bias leads to the core of the momentum strategy – investment decisions are made by assuming past winners indicate future winners and past losers indicate future losers.

The Evidence

Empirical research has yielded evidence that the momentum premium (momentum strategy outperformance) exists. Numerous studies have found time series momentum strategies across a number of asset classes (including equity index, currency, commodity, and bond futures) are capable of delivering excess returns. [2] Furthermore, academic researchers have examined stock data going back over 200 years and identified a significant and robust historical performance record, which has confirmed the momentum premium inside and across asset classes. [3] Looking at the UK market, the momentum premium has historical precedent dating back to the Victorian age [4]. Since the time of the formal discovery of the momentum premium there have been decades of further research proving its existence – which has covered 40 additional countries and over a dozen additional asset classes [5].

Inukshuk Capital Management’s research has independently verified many of the empirical results associated with momentum resulting from the previously cited research [3] carried out by Geczy and Samonov. Given the extent of the historical analysis – some of which predates formally recorded academic research in financial economics – it has been established that the momentum premium is present in markets. So much so that certain academic research assumes the momentum premium existed even before researchers engaged in the science of searching for it [7].

The Benefits

Momentum strategies can generate excess risk-adjusted returns. With the correct data screen in place to identify momentum opportunities, alongside the application of a strict discipline in trading the strategy, investment outperformance is possible. A further benefit of momentum investing is being able to utilize market volatility to the investor’s advantage. The investor is able to capitalize on volatile market trends by following, or avoiding, market movements as they trend upwards or downwards. There are risk management benefits to momentum investing also – a diversified portfolio of time series momentum strategies across all asset classes has been shown to deliver excess risk-adjusted returns with little exposure to standard asset pricing factors that can perform well in extreme market conditions[2].

The major benefit of this strategy is that investors can take advantage of the behavioral bias of other market participants. By applying a systematic process that identifies when the wider market is chasing performance up or down, the investor is capable of capturing excess returns. There are a number of emotional biases that momentum investors can capitalize upon in applying momentum strategies – by identifying “herd mentality” based behaviors in the market. These behaviors include: holding onto losing stocks too long, selling a stock too early when it is rising and the tendency for the wider market to place a disproportionate amount of emphasis on the most recent economic events. Momentum investors can apply these ideas towards taking advantage of the emotional responses of other market participants and the corresponding market dynamics that will result in price changes.

Future Return Potential

Given the historical research and record of momentum investing, the question naturally arises whether the excess returns to be made from this strategy will persist in the future. Momentum strategies have grown in popularity but this does not necessarily mean the potential excess returns will be eroded away by over-crowding.

Evidence suggests the strategy will be profitable going forward. To begin with, human nature has not evolved so far as to eradicate the behavioral biases discussed that may lead to the momentum premium. The fact that momentum investing is often driven by persistent under-reaction to positive fundamentals remains true [6]. Recent research has furthermore indicated that the returns from momentum investing are likely to continue with significant size and consistency over time to maintain profitability and overcome associated costs. [7] Research published in 2014 has also shown that momentum strategies lead to outperformance on both the short and long side and will work well with both large and small capitalization stocks. [7]

Conclusion

When these factors are taken under consideration, and in combination, it is logical and sound to conclude that future excess returns can be generated from momentum investing. The key to successfully applying this strategy is a disciplined approach to research in identifying momentum premium opportunities in various asset classes, time frames, geographies and sectors. Equally crucial is a disciplined trading approach – exit and entry points are critical to the level of outperformance in momentum investing. With a rigorous systematic process for research, decision making, trading and portfolio construction set in place momentum strategies can lead to significant outperformance of portfolio returns over time.

Sources

[1] Fama, E. and K. French, 2008, Dissecting Anomalies, The Journal of Finance, 63, pg. 1653-1678.
[2] Time Series Momentum, Journal of Financial Economics, Vol 104, Issue 2, May 2012, Moskowitz, Ooi and Pedersen, http://www.sciencedirect.com/science/article/pii/S0304405X11002613
[3] 215 Years of Global Multi-Asset Momentum: 1800-2014 (Equities, Sectors, Currencies, Bonds, Commodities and Stocks) https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2607730
[4] Chabot, Ghysels, and Jagannathan (2009).
[5] Asness, Moskowitz and Pedersen (2013).
[6] The Quantitative Momentum Investing Philosophy
http://blog.alphaarchitect.com/2015/12/01/quantitative-momentum-investing-philosophy/#gs.oWR=3dg
[7] Fact, Fiction and Momentum Investing, 2014
https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2435323&