Relative Strength: How Does Momentum Investing Work?

http://www.businessinsider.com/relative-strength-how-does-momentum-investing-work-2011-7

In Brief
An investing strategy of buying prior winning stocks and selling short prior losers
based on the empirical observation that Investments exhibit persistence in their
relative performance. As George Chestnutt wrote back in 1965: “Which is the best
policy?  To buy a strong stock that is leading the advance or to quot;shop
aroundquot; for a quot;sleeperquot; or quot;behind-the-marketquot; stock in the
hope that it will catch up?  . … Many more times than not, it is better to buy the 
leaders and leave the laggards alone.  In the market, as in many other  phases of
life, quot;the strong get stronger, and the weak get weaker.quot;

Background
Buying winners inherently conflicts with the contrarian philosophy that is part and
parcel of many successful investors. Nevertheless, it has long been noted by traders
that good performing investments tend to continue to do so, whereas those that have
performed relatively poorly tend to continue on the same path.

Momentum investing is not to be confused with growth investing, short-term price

acceleration, or general trend following. It usually involves a disciplined, systematic
investing style based on relative price strength over a specific (usually 6 to 12
months) formation period combined with systematic entry and exit rules. 

Definition of a Relative Strength Screen

Richard Driehaus is an example of an investor with a heavy momentum bias,
blending earnings and price momentum. However, an indicative 'pure momentum'
screen might be: 

 Exclude the most illiquid stocks, e.g. the bottom 25% of stocks based on
market capitalisation

 High relative strength in the last six months compared with the market
(top 25%) - relative strength doesn't work over short timeframes, such as one
month.

 High relative strength in the previous twelve months compared with

the market (top 25%), with the 12 months being higher than the three months

 The hold period for investments would typically also be in the 3-12 month
range.

Adding value and/or earnings momentum criteria usually increases the screen
effectiveness (see below).
Interestingly, this study  showed that individual investors tend to be relatively bad at
applying momentum investing strategies effectively, as against professional
investors.

How Well Does it Work?

Academics have focused on studying momentum investing properly for the better
part of two decades. A study by Hancock found a momentum strategy outperformed
a broad universe of U.S. stocks by nearly 4% per year from 1927-2009.

Likewise, the AQR Momentum Index showed a 10 year CAGR of 13.7% (18.6%
volatility) vs. 11.2% for the Rusell 1000 Index (15.7% volatility). Some research
suggests that momentum investing delivers even better abnormal performance than
either size or value styles. Momentum’s effect exists in nearly all sizes/sectors,
different asset classes and international markets. It does however depend on the
investment time horizon. Most academic studies of momentum skip the most recent
month, since “there exists a reversal or contrarian effect in returns which may be
related to liquidity or microstructure issues” (Jegadeesh). Overall,
trading based on individual stock momentum appears to be a poor strategy over a
short historical horizon (especially less than one month); it is highly profitable at
intermediate horizons (up to 24 months, but especially in the 6- to 12-month range);
and is once again a poor strategy at long horizons (beyond 24 months).

Research has shown that momentum is particularly beneficial when combined with a

value style because the two are negatively correlated. Moskowitz and Grinblatt
conclude that “A value-momentum combination mitigates the extreme negative
return episodes a value investor will face (e.g., the tech boom of the late 1990s and
early 2000 or a dismal year like 2008)”. Research also indicates that momentum can
be a catalyst to value, i.e. the research suggests that value stocks that have been long-
term losers but have high 6–12 month returns will go on to outperform by an even
wider margin.

Why does it work?

Research is ongoing but the most likely explanation is that momentum is a
phenomenon driven by investor behavior and the quot;bandwagon” effect. Following
the Nobel prize-winning work of Daniel Kahneman and Amos Tversky, several
possible behavioral explanations have been put forth:

i) Slow reaction to new information. Different investors receive news from

different sources and react to news over different time horizons and in different
ways, creating an “anchoring and adjustment” effect whereby in which individuals
update their views only partially when faced with new information, slowly accepting
its full significance.

ii) Asymmetric responses to winning and losing investments. Investors

tend to sell winning investments prematurely to lock in gains and hold
on to losing investments too long in the hope of breaking even. The disposition effect
creates an artificial headwind, i.e. when good news is announced, the price of an
asset does not immediately rise to its true value because of premature selling or
lack of buying. 
Interestingly, research by Scowcroft and Sefton found that,  when it comes to large-
cap stocks, price momentum is largely driven by the momentum of a stock's broader
industry sector and not by the momentum of the individual stock itself. 

Watch Out For

Like any strategy, momentum does not deliver positive returns all the time. Research
by Hancock found that the strategy suffered during periods of high stock market
volatility and that the strategy had poor relative performance in the six months
following recent bull market tops and bear market bottoms. He also came to the
conclusions that quot;volatility is bad for momentum, largely because volatility is
associated with mean reversion and not trendingquot;.  

It also has a more volatile return profile - even though the AQR Momentum Index
had a 22% higher return than the Russell 1000 index during the ten year period
discusssed above, it also had 18% more volatility.

As it's an investment strategy with a relative short time horizon, the trading

costs of momentum investing are higher than those of value and growth, but they are
reportedly not high enough to materially change the attractiveness of momentum
(Israel and Moskowitz 2010, not yet published).

From the Source: 

Jegadeesh and Titman’s 1993 paper “Returns to Buying Winners and Selling Losers:
Implications for Stock Market Efficiency” generally get the credit for “discovering”
the momentum effect in academic circles. Their work showed that simple relative
strength strategies that rank stocks based on their past 3-12 month returns predicted
relative performance over the next 3-12 months.

Other Sources:
There are now over 300 momentum papers published in academic journals.  For a
brief review of some of the prominent research papers, see AQR Capital
Management’s Annotated Bibliography of Selected Momentum Research Papers. See
also:

 Momentum Investing  - Finally Accessible for Individual Investors

 Momentum – A Contrarian Case for Following the Herd

 Value and Momentum Everywhere

 The Case for Momentum Investing

 3 Ways Momentum Investing can Harm Your Portfolio

 Optimal Momentum: A Global Cross Asset Approach

 AQR Momentum Indices