Comprehensive Guide to Momentum Investing

What’s in this article:

An easy-to-understand overview of Momentum Investing
The evidence from well-known Global academic and practitioner research on Momentum Investing
Why does Momentum Investing work? The behavioural reasons
What our research into Momentum Investing in Indian markets showed [Whitepaper]
Investor’s Guide to Momentum Investing - we discuss on the Livemint podcast [Podcast]
Demystifying Momentum: Real-world lessons from running a best-performing Momentum PMS Strategy in India with a five+ year track record [Video]

Momentum Investing in a nutshell

Momentum Investing is a strategy that picks stocks with higher relative returns over the recent past and holds them for a defined period. The underlying hypothesis is that such stocks will continue to outperform the market for some time in the future. Historical and live performance reviews have shown that momentum investing outperforms buying and holding the market index.

How can such a simplistic strategy offer long-term outperformance versus the market?

This page combines a curated and comprehensive set of research and resources on Momentum Investing globally and specifically in India, based on our experience running India’s longest-running Momentum PMS Strategy. The resources on this page should offer investors new to and familiar with momentum investing a perspective on how and why momentum works. Links to the original papers are references for those who’d like to dive into them.

Returns to buying winners and selling losers

Narasimhan Jegadeesh and Sheridan Titman from Anderson Graduate School of Management, UCLA, published one of the earliest mainstream academic studies on momentum investing in 1993.

Abstract: This paper documents that strategies which buy stocks that have performed well in the past and sell stocks that have performed poorly in the past generate significant positive returns over 3- to 12-month holding periods. We find that the profitability of these strategies are not due to their systematic risk or to delayed stock price reactions to common factors. However, part of the abnormal returns generated in the first year after portfolio formation dissipates in the following two years. A similar pattern of returns around the earnings announcements of past winners and losers is also documented.

The researchers tested various portfolios built using a "J-month / K-month" strategy. Stocks were picked based on the returns of the past J months and held for K months after portfolio formation. Both J and K varied from 3 to 12 months, in three-month increments. The research tested every combination.

Their finding was that all combinations of past returns and holding periods, barring one, outperformed a basic buy-and-hold strategy net of costs.

Reference:

Jegadeesh, Narasimhan, and Sheridan Titman. “Returns to Buying Winners and Selling Losers: Implications for Stock Market Efficiency.” The Journal of Finance 48, no. 1 (1993): 65–91. https://doi.org/10.2307/2328882.

Industry Momentum Effect

This 1999 paper by Tobias J. Moskowitz of the Chicago Graduate School of Business (now Chicago Booth), and Mark Grinblatt of Anderson School of Business, UCLA examined the industry component in a stock’s momentum on 32 years of data from 1963 to 1995.

Abstract: This paper documents a strong and prevalent momentum effect in industry component of stock returns which accounts for much of the individual stock momentum anomaly. Specifically, momentum investing strategies, that buy past winning stocks and sell past losing stocks, are significantly less profitable once we control for industry momentum. By contrast, industry momentum investment strategies, which buy stocks from past winning industries and sell stocks from past losing industries, appear highly profitable, even after controlling for size, book-to-market equity, individual stock momentum, the cross-sectional dispersion in mean returns, and potential microstructure influences.

The findings suggest that industry momentum explains a large part of individual stock momentum and that industry momentum persists even in the largest, most liquid stocks.

International Momentum Strategies

This paper by Prof. Greet Rouwenhourst, Robert B. and Candice J. Haas, Professor of Corporate Finance at Yale Som School of Management, studied the prevalence of momentum in emerging markets from 1980 to 1995.

Abstract: International equity markets exhibit medium-term return continuation. Between 1980 and 1995 an internationally diversified portfolio of past medium-term Winners outperforms a portfolio of medium-term Losers after correcting for risk by more than 1 percent per month. Return continuation is present in all twelve sample countries and lasts on average for about one year. Return continuation is negatively related to firm size, but is not limited to small firms. The international momentum returns are correlated with those of the United States which suggests that exposure to a common factor may drive the profitability of momentum strategies.

Reference:

International Momentum Strategies; K Geert Rouwenhorst: https://doi.org/10.1111/0022-1082.95722

Time Series Momentum

By Tobias Moskowitz, Yao Hua Ooi, and Lasse Hej Pedersen, the paper expanded the scope of examining momentum to over 25 years of data on five dozen diverse financial instruments, including country equity indices, currencies, commodities and sovereign bonds.

Abstract: We document significant “time series momentum” in equity index, currency, commodity, and bond futures for each of the 58 liquid instruments we consider. We find persistence in returns for 1 to 12 months that partially reverses over longer horizons, consistent with sentiment theories of initial under-reaction and delayed over-reaction. A diversified portfolio of time series momentum strategies across all asset classes delivers substantial abnormal returns with little exposure to standard asset pricing factors and performs best during extreme markets. Examining the trading activities of speculators and hedgers, we find that speculators profit from time series momentum at the expense of hedgers.

There is a distinction between time-series momentum and the regular definition of momentum, which is cross-sectional. Time-series momentum compares a security's recent return with its own historical return, while cross-sectional momentum compares securities with other securities over the same time period.

Reference:

Time Series Momentum: Asness, Ooi, Pedersen: Paper

A century of trend-following investing

The analysis considers monthly returns for 67 markets across four major asset classes: 29 commodities, 11 equity indices, 15 bond markets, and 12 currency pairs. They constructed equal-weight combinations of 1-month, 3-month, and 12-month time-series momentum strategies, rebalanced monthly, from Jan 1880 to Dec 2016, 136 years. The results showed an 11% annualised excess return over the period considered.

Even assuming a 2-and-20 fee model (2% of AUM as fixed fee and 20% of gains), a momentum-based strategy outperformed net of costs in every decade from 1880 to 2016, with a minimum outperformance of 2.6% from 1880 to 1889 and a maximum of 15.1% from 1970 to 1979.

Reference:

A century of trend-following investing: Hurst, Ooi, Pedersen: Journal of Portfolio Management Paper

Fact, Fiction and Momentum Investing

Published in the Journal of Portfolio Management, this paper was authored by Cliff Asness, Andrea Frazzini, Ronen Israel, and Tobias Moskowitz of AQR Capital.

On the first page, they make this telling assertion about the prevalence of momentum as a factor for outperformance, not only in stocks but across assets and countries:

"The existence of momentum is a well-established empirical fact. The return premium is evident in 212 years (yes, this is not a typo, two hundred and twelve years of data, from 1801 to 2012) of US equity data, dating back to the Victorian age in UK Equity data, in more than 20 years of out-of-sample evidence from its original discovery, in 40 other countries, and in more than a dozen other asset classes."

Subsequently, they examine and debunk several myths about momentum investing, including whether its outperformance was limited to small-cap stocks or non-existent when considered net of costs. The outcome shows persistence in momentum's outperformance over passive benchmarks in each case.

Reference:

Fact, Fiction and Momentum Investing (aqr.com)

Momentum: The premier anomaly

Eugene Fama is the Robert R. McCormick Distinguished Service Professor of Finance at the University of Chicago Booth School of Business (formerly the Chicago Graduate School of Business). His biography page on the Chicago Booth website refers to him as the "father of modern finance". A significant part of that honorific rests on his 1970 research on the efficiency of Capital Markets.

The Efficient Capital Markets Hypothesis states that capital markets are efficient in processing information. So, stock prices at any time are based on the correct evaluation of all available information at that time. In an efficient market, prices fully reflect available information. And if all information is correctly reflected in prices at any time, there is no way to profit from identifying mispricing.

For his research on Efficient Capital Markets, Prof Fama and his co-authors, Robert j Shiller and Lars Peter Hansen were awarded the Nobel Prize for Economic Sciences in 2013.

This research went a long way in the emergence of passive investing and making EMH a core part of the finance curriculum in business schools worldwide.

In 2008, Prof Fama published a paper titled "Dissecting Anomalies", which explored returns from specific investment strategies that did not conform to the Efficient Market Hypothesis. In this paper, he and his co-author Kenneth R French, based on an analysis of 42 years of data from 1963 to 2005, concluded that "anomalous returns associated with net stock issues, accruals, and momentum are pervasive."

Over time, the other stock-picking strategies were challenged and sometimes successfully. Momentum, as an aberration to the Efficient Markets Hypothesis, has endured, leading Prof. Fama to call it the “premier anomaly”.

References:

“Efficient Capital Markets: A Review of Theory and Empirical Work.” The Journal of Finance 25, no. 2 (1970): 383–417. https://doi.org/10.2307/2325486

“Dissecting Anomalies.” Fama, Eugene F., and Kenneth R. French. The Journal of Finance 63, no. 4 (2008): 1653–78. http://www.jstor.org/stable/25094486

So, Momentum Investing works. But why?

Researchers have proposed several behavioural explanations for why a strategy that buys past winners and sells past losers consistently outperforms the market across asset classes and countries over centuries of data.

Underreaction (or Anchoring Bias or the Frog-in-the-Pan hypothesis):

Investors are inattentive to information arriving continuously in small amounts, so frequent gradual changes attract less attention than infrequent dramatic changes. This means a company with consistently improving performance would not attract significant attention, offering the opportunity for a momentum strategy and to enter and ride the gradual price rise.

Reference:

Zhi Da, Umit G. Gurun, Mitch Warachka, Frog in the Pan: Continuous Information and Momentum, The Review of Financial Studies, Volume 27, Issue 7, July 2014, Pages 2171–2218, https://doi.org/10.1093/rfs/hhu003

Disposition Effect:

A natural inclination to sell winners but hold on to losers to avoid losses. This means consistent selling from existing investors acts as a brake on the stock price, making the price rise more gradually and, therefore, allowing a momentum strategy to enter

Reference:

Mark Grinblatt, Bing Han, Prospect theory, Mental Accounting and Momentum, Journal of Financial Economics, Volume 78, 2005, http://www-2.rotman.utoronto.ca/facbios/file/momentum_JFE.pdf

Cognitive Dissonance:

News that contradicts investor sentiments causes cognitive dissonance, which tends to get ignored or disbelieved, thus slowing its diffusion into stock prices. Thus, losers keep getting underpriced while winners keep getting overpriced, sustaining their momentum.

Reference:

Antoniou, C., Doukas, J., & Subrahmanyam, A. (2013). Cognitive Dissonance, Sentiment, and Momentum. Journal of Financial and Quantitative Analysis, 48(1), 245-275. doi:10.1017/S0022109012000592

Momentum Investing In India

Multiple global research papers have confirmed the persistence of momentum. We did our own study into Indian markets and how momentum has performed in India.

We examined a few variants of a momentum investing strategy, Naive momentum, along with volatility-adjusted versions. All momentum portfolios comfortably outperformed a Nifty Buy-and-Hold strategy. Adding volatility-adjusted Sharpe return ratios helped improve the risk-return profile of the strategy by reducing the impact of sharp market drawdowns on portfolio performance.

Reference:

Vijaykumar, Anoop, Does Momentum Investing Work in Indian Equities? (May 30, 2020). Available at SSRN: https://ssrn.com/abstract=3614509 or http://dx.doi.org/10.2139/ssrn.3614509

The Livemint Podcast: Investor’s Guide to Momentum Investing

Our Fund Manager and Head of Research, Anoop Vijaykumar, is on the Livemint Podcast discussing Momentum Investing in India from a practitioner’s perspective and what investors should consider when investing in a momentum strategy.

Capitalmind Adaptive Momentum: India’s longest-running top-performing Momentum PMS

Watch our video “Demystifying Momentum”

With over five years of managing real money, Capitalmind Adaptive Momentum is the longest-running successful Quantitative Momentum Investing strategy in India. Watch our video discussing the how we run a momentum investing strategy, why it works, and real-world lessons from Momentum Investing in India.