Momentum Factor Investing: Riding the Wave to Returns

Momentum factor investing is a strategy that focuses on identifying stocks or assets that have been performing well recently. This approach is based on the idea that past winners tend to continue winning.

By riding the wave of momentum, investors can potentially tap into the power of compounding returns. According to research, stocks with high momentum have historically outperformed the market.

In fact, a study found that the momentum factor has been a consistent source of alpha, with an average annual return of 8.5% over a 10-year period. This is significantly higher than the average return of the overall market.

Investors who have successfully implemented momentum factor investing strategies often cite the importance of patience and discipline in their approach.

The existence of momentum in asset prices has had a significant impact on investment practice and theory.

Empirical evidence supporting momentum has led to the development of a reliable and profitable investment strategy that can be implemented across various asset classes and by different types of investors.

The average monthly return across geographies and assets is substantial, as shown in Figure 1.

Momentum profits on a wide-scale basis challenge the theory of weak form market efficiency, which is a fundamental concept in finance.

Even prominent academics like Fama have expressed frustration with the existence of momentum, with Fama stating that "Momentum is the biggest embarrassment to the theory" and "I wish it would go away".

Investors naturally follow the herd, chasing after performing stocks, driven by behavioural biases.

Fund managers, even those who have underperformed, might sell losing positions and jump on the bandwagon of winning stocks to catch up with their peers.

Retail investors often do the same, picking stocks that are in the news and showing strong returns.

Momentum is sector and theme agnostic, meaning it doesn't care about sectors, themes, or valuations.

It can shift from growth-oriented tech names to more cyclical sectors like materials and financials driven by bullish commodity markets and low interest rates.

Momentum has captured the AI rally, a trend that initially faced scepticism but has since gained widespread acceptance.

Value investing is a timeless strategy that's stood the test of time. It's about finding undervalued companies with strong fundamentals and holding onto them for the long haul.

A value investor looks for companies with low price-to-earnings ratios, indicating they're trading at a discount to their true worth. This can be a great way to buy low and sell high.

The Warren Buffett philosophy emphasizes the importance of owning a small number of high-quality businesses. He's a master of finding hidden gems and holding onto them for decades.

Momentum is my top choice for investment strategies. It's a powerful factor that can help you capture the next big trend.

Investors often exhibit a natural tendency to follow the herd, chasing after stocks that are performing well. This behavioural bias creates opportunities for those who know how to exploit it.

Long-term structural trends can lead to sustained earnings growth, making it easier for companies to raise funds for new business opportunities. This fuels the next leg of earnings growth.

Momentum is sector and theme agnostic, meaning it doesn't care about sectors, themes, or valuations. It can capture trends in any industry or market.

The COVID-19 market rebound in mid-2021 is a great example of momentum in action, shifting from growth-oriented tech names to more cyclical sectors like materials and financials.

The momentum factor has its risks, but it's not without its rewards. Volatile markets can disrupt existing trends, catching momentum strategies off guard. For example, the 2022 inflation shock saw the market rotate out of high-growth tech stocks into value-oriented energy stocks.

Spikes in the VIX Index above 30 often signal potential momentum crashes. This can be a red flag for investors to reassess their momentum strategy.

Momentum strategies involve high turnover, leading to higher trading commissions and potential slippage in less liquid market conditions. This can erode returns over time, so it's essential to understand the turnover and associated frictional costs.

The cost of alpha is not free; it comes with risks. The momentum factor has excess kurtosis, or fat-tails, which means that when returns are bad, they are really bad. In a worst-case scenario, there's a 5% chance of losing more than 27.5% in a year.

Riding the wave of momentum investing can be a thrilling experience, but it's essential to acknowledge the risks involved. Volatility is a significant enemy of momentum, and spikes in the VIX Index above 30 often signal potential momentum crashes.

Momentum strategies involve high turnover, which can lead to higher trading commissions and potential slippage in less liquid market conditions. This can erode returns over time.

The distribution of monthly returns for the momentum factor shows that returns are positively skewed, with more months of positive returns than negative returns. This is great for an asset allocator seeking consistent alpha capture.

However, the downside of using the momentum factor is that there will be a few times when the returns are much worse than the market. Approximately 95% value-at-risk (VaR) of momentum factor is 27.5%, implying a 5% chance of losing more than 27.5% in a year.

The COVID-19 pandemic had a significant impact on financial markets, leading to an improvement in the performance of the industry-momentum factor.

In the first half of 2020, most of the return occurred between February 21 and April 3, as seen in the MSCI Global Total Market Equity Trading Model.

The performance of the industry-momentum factor was particularly strong during this period, with returns concentrated in a short window of time.

This period of improved performance was a notable exception to the typical behavior of the factor, which often exhibits more consistent returns over time.

The industry-momentum factor's performance during the pandemic was a notable example of how unexpected events can impact financial markets and investment strategies.

The momentum factor has been a key driver of stock returns in the US equity market, accounting for approximately 1.7% of the average stock's return from 1928 to 2020.

Momentum stocks tend to be more volatile than the overall market, with the average momentum stock experiencing a standard deviation of 32.6% compared to the market's 19.5%.

Momentum factor investing has been particularly effective in the US market, where it has been shown to outperform the market in 57% of months since 1928.

The industry-performance landscape varied significantly across different regional models.

The COVID-19 pandemic had a profound impact on financial markets, leading to a notable improvement in the performance of the industry-momentum factor.

Looking at the MSCI Global Total Market Equity Trading Model, most of the return occurred between February 21 and April 3, 2020.

The Factor Archives is a treasure trove of industry insights. It's a database of historical trends and patterns that can help us make sense of the current market.

The archives reveal that the industry has experienced a significant shift in the past decade, with a 25% increase in digital adoption. This has led to a major change in consumer behavior.

Companies that have adapted to this shift have seen a notable increase in revenue, with some reporting a 50% growth rate. Those who have failed to adapt, on the other hand, have struggled to stay afloat.

The archives also show that the industry is highly cyclical, with trends and patterns repeating themselves every 5-7 years. This is evident in the 2010s, when the industry experienced a similar shift towards digitalization.

Understanding these cycles can help businesses anticipate and prepare for future changes. It's not just about reacting to current trends, but also about anticipating what's to come.

The archives suggest that the industry will experience another significant shift in the next 2-3 years, driven by emerging technologies such as AI and blockchain.

GICS sub-industries played a significant role in the momentum factor's performance. The factor's total performance was driven by 20 out of 158 sub-industries that continued to follow the same performance trend as in recent history.

The top 10 positive contributors to the factor's return were dominated by sub-industries negatively affected by COVID-19. Hotels, resorts & cruise lines led the pack with a +0.9% contribution, followed closely by retail REITs with a +0.7% contribution.

Here are the top 10 positive and negative contributors to the factor's return: