Creating momentum for investors

Following the market trends can provide a source of returns, but the strategy is not risk-free.

Summary: Evidence suggests momentum or trend trading can offer potential returns. But investors should be aware that trying to replicate a trading strategy to capture ‘momentum’ through short term buying and selling would generate significant tax and transaction costs.

Key take-out: Momentum trading is an interesting idea to guide investing but the risks need to be considered.

Key beneficiaries: General investors. Category: Portfolio management.

There seem to be three sources of ‘returns’ from share markets that are largely agreed on by many researchers.  These are that:

  • There is a return over time from investing in a portfolio of shares – the average market return or ‘index’ return. It is expected that over long periods, this return will be higher than investing in cash.
  • Over long periods of time it is expected that small companies provide a higher return than larger companies – a ‘small company premium’.
  • Over long periods of time it is expected that value companies (companies that trade at a lower price compared to their dividends, earnings or book value) provide a higher return – a ‘value premium’.

None of these returns are expected to provide a ‘free lunch’ – investing in shares rather than cash means that a portfolio will be ‘volatile’, and small and value companies have periods of additional volatility and underperformance of the average market return – currently small companies are going through a period of underperformance of the average market.

Momentum

There is a further source of returns that many researchers have identified – that of ‘momentum’.  This refers to the tendency for shares that provide a positive return in one period (for example over six months), to tend to provide a more positive return that the average market return over the next period.  The opposite also holds true – negative momentum is identified as well.

An interesting element to this is that it is supported by some of the more practical ‘market wisdom’ that exists.  ‘Don’t try to catch a falling knife’ – meaning not to buy shares while they are falling in value and ‘the trend is your friend’ both tie into the ‘momentum story’.

The Research

There have been many academic papers that consider the impact of momentum in share market returns. The 1997 paper by Mark Cahart from the 1997 Journal of Finance ‘On Persistence in Mutual Fund Performance’ is considered one of the most significant analysis of the factors that impact managed (mutual) fund performance and identified momentum as a source of returns.

Most of the research considers time frames of up to 12 months. For example, the researchers might look at which shares provided above – or below – average returns over a 6-month period, and then looked to see whether these shares continued to provide a higher – or lower ­– return over the next 6-month period.

Philip Stork considered the possible role of momentum in Australia share market returns in the paper ‘Momentum Effects in the Largest Australian and New Zealand Shares’ published in 2008 in INFINZ Journal. They look at the biggest 20 shares in the Australian market from the period 1998 to 2008, to see if there is evidence of momentum in the Australian market.  They find that shares with positive momentum over a three, six and 12-month period then provide higher returns over subsequent three, six and 12 month periods. The author’s conclusion:We analyze momentum effects in the largest twenty Australian and fifteen New Zealand shares. We find that in the medium-term, past winners continue to outperform past losers. The results are statistically significant’.

The Practical Reality

In the world of theoretical share market research, a component of interest to the individual investor that is often overlooked is the issue of tax – and often transactions costs.  Trying to replicate a trading strategy to capture ‘momentum’ through short term (say every six months) buying and selling would generate significant tax and transaction costs for most investors.

I think that it is better used as a ‘screen’ when considering adding or selling shares – have a look at what the three to nine month performance of the shares have been compared to the market and consider whether it might be better to wait before buying shares with negative momentum, or selling shares with positive momentum.

Why Might Momentum Exist?

There are a number of behaviour theories that try to explain the existence of momentum.  A couple of the more common are linked to the idea of ‘under-reaction’ to news.  For example, if a company were to report a sharply increased profits there share price would increase – however not by as much as it should.  Therefore the share price takes a period of time to react completely to the good news – creating a momentum effect. 

Conclusion

There is evidence that momentum – the continuation of stronger (or poorer) returns from one time period of less than 12 months to the next – is a source of returns in share markets.  This evidence is not undisputed, and there are periods where returns from a ‘momentum strategy’ have been negative.  However, it remains an interesting source of potential returns, that might be used by individual investors considering the timing of trading decisions.


Scott Francis is a personal finance commentator and previously worked as an independent financial advisor.