Momentum is like gravity
Momentum is the much ascribed theory that a stock whose price is rising faster than its peers will continue to rise, and a stock whose price is falling faster than its peers is set to continue to fall. FT journalist David Stevenson describes momentum (and the evidence behind it) as “the dirty secret of modern investment research” in last Friday’s MoneyWeek publication. He states the existence of momentum as a well-established empirical fact, citing Jagadeesh and Titman’s 1993 paper: Returns to Buying Winners and Selling Losers: Implications for Stock Market Efficiency. More recent research from Cliff Asness of investment firm AQR has shown that the momentum risk-premium has been evident in the US in 212 years (!!) of financial data from 1801 to 2012.
This therefore begs the question should momentum be considered a dimension of return, and if so how can we exploit it? The problem we see with momentum is that in practical terms it can be difficult to exploit without incurring expensive trading costs which can quickly wipe out any premium that exists. Furthermore, momentum has suffered periods when it has NOT worked, as per the last few years. To pass the test for a dimension of return, momentum needs to be pervasive, persistent and sensible. It passes some of these tests, but not all, and most strikingly it does not appear to be particularly sensible.
Momentum is like gravity: it exists and to ignore it would be foolish, however it is tough to explain, and can be expensive to exploit. The funds we use favour the use of momentum through the following intuitive strategy, as a small or value stock increases in price, it begins the journey towards becoming a large or growth stock. Eventually at some point if the increase continues, the fund manager will be obliged to sell. However if it can be proved that the stock in question is rising faster than its peers, and thus experiencing momentum, the fund’s traders will delay the sell order until the stock price has settled. Conversely, the opposite strategy is applied for a stock whose price is falling faster than its peers (and therefore moving into the small and value space), which is to delay the buy order until the stock price settles.
In this way it is intuitively and inexpensively possible to make use of momentum, which seems a sensible strategy to adopt for a phenomena that is tough to sensibly explain.