Why Is Momentum Investing Picking Up Pace?

Why Is Momentum Investing Picking Up Pace?

Over the last one year the Indian stock markets have persistently been recording new highs and going from strength to strength. Concurrently, momentum investing has thrust into limelight and is gaining traction among investors. In this special feature Armaan Madhani helps us delve deep to understand momentum investing and explore its historical performance in the Indian capital markets


 

Factor investing approach entails targeting distinct and peculiar drivers of return across asset classes. Investing in such factors has helped investors reduce risk and materially outperform frontline indices by a decent margin for decades. These factors are basic foundations of investing such as value, size, quality, volatility and momentum. Momentum investing is a type of factor investment strategy which aims to purchase financial assets such as stocks, bonds, commodities or derivatives that have been exhibiting an upward price trend or short-sell securities that display a downward price trend. In essence, the strategy states that stocks with high returns in past periods tend to have high returns in coming future periods and stocks with low returns tend to have low returns in the future. Keep in mind the age old adage: ‘the trend is your friend’.

Characteristics of Momentum Investing

The primary rationale is that top performing financial securities maintain the same momentum and continue to follow a similar upward trend for a certain time period in the future and vice-versa. The objective is to take advantage of market volatility by discovering investment opportunities in the short or medium term price trends of securities. A momentum investor will purchase a stock that has consistently been on the rise and will exit as soon as signs of decline are evident. Momentum investing is a technical short-term strategy that often plays over 6-12 months and rarely focuses on a company’s fundamental performance. Momentum investing generally tends to leverage behavioural weaknesses such as herd mentality bias of other investors in the markets.

Oft-times investors under-react to data releases, news and events. On the other hand, once things become clear and comprehensible, investors over-react and follow the herd, thereby causing a substantial movement of stock price in either direction. Also, emotions such as greed, overconfidence or plain fear of missing out (FOMO) frequently steer investors towards top performers or market darlings even after they have rallied significantly. Awareness of these behavioural biases has lent a helping hand to momentum investors by considerably enhancing the effectiveness of the strategy. For decades the classic traditional investment mantra has been ‘buy low, sell high’; however, momentum investing defies this conventional wisdom.

Momentum strategy aims at buying high and selling even higher. This makes momentum investing counter-intuitive to all other investment strategies. Instead of selling their topperforming stocks, investors increase stake in them and exit their worst-performing stocks without waiting for a bounce back. It resonates with the prominent proverb – ‘cut your losses and let your profits run.’ Ergo, momentum investing is the opposite of value investing. To quote renowned finance blogger Ben Carlson, “Value investing is based on a long-term reversion to the mean. Momentum investing is based on that gap in time that exists before mean reversion occurs. Value is a long game, while momentum is usually seen in the short- to intermediateterm.”

History of Momentum Investing

The idea of momentum investing has been around for as long as organised investing. We don’t know who ‘invented’ momentum investing, but its prominence can be traced back to 1993 when a paper by two professors at University of California, Narasimham Jegadeesh and Sheridan Titman, was published in the Journal of Finance. The paper is called ‘Returns to Buying Winners and Selling Losers’ and tested NYSE stock returns from 1965 to 1989. At the time, they called it ‘relative strength’ strategy. They concluded that trading strategies that buy past winners and sell past losers realised significant abnormal returns over the 1965 to 1989 period. This idea was executed by Chicago-based fund manager Richard Driehaus who turned it into a strategy to run his funds. In 2004, he told Crain’s Chicago Business, “I believe that more money can be made buying high and selling at even higher prices. I try to buy stocks that have already had good price moves, that are often making new highs and that have positive relative strength.” Many of the techniques used by Richard Driehaus became the basics of momentum investing. Over the years momentum investing has been studied extensively. According to a paper titled ‘Fact, Fiction and Momentum Investing’ published in 2014, “The existence of momentum investment is a well-established empirical fact. The return premium is evident in 212 years of US’ equity data from 1801 to 2012 as well as the UK equity data dating back to the Victorian age in over 20 years of out-of-sample evidence from its original discovery, in 40 other countries and in more than a dozen other asset classes.

Types of Momentum Investing

There are two types of momentum investing:

Relative Momentum : As the name suggests, in this strategy we compare the historical performance of a stock to its peers and then shortlist the stocks which have outperformed their peers. Investors then invest in these stocks hoping that they will outperform in the near future as well.

Absolute Momentum : In this strategy we compare the recent performance of a stock with its own historical performance. Investors then take long positions in positive performing stocks and short-sell negative performing stocks. In a nutshell, relative momentum measures how a particular financial security has performed in relation to other securities and absolute momentum examines whether a particular investment has actually risen in value over the past periods.

Drawbacks of Momentum Investing

Momentum investing is a high-risk, high-reward strategy. It has its fair share of drawbacks such as:

• High Churn or Turnover: Momentum investors exit their positions as soon as signs of trend reversal become evident. Similarly, they also take new positions as positive trends are observed. Unlike value investing, there is a high degree of portfolio churn or turnover for momentum investing which translates into high transaction costs and fees. Since it is short term, investors also have to bear the brunt of short-term capital gains tax.
• Market Sensitivity: Momentum is highly prone to market sensitivity. The momentum investing strategy thrives in a bull market as there is ample liquidity and investors are gung ho; hence, the herding bias is at its zenith. While in a bear market phase where pessimism is rife, the strategy at times tends to underperform.
• Time Sensitivity: To successfully execute the momentum investing strategy investors have to be alert and keep a close on the market details daily. If an investor holding a position fails or misses to recognise a reversal in trend, it could easily lead to sharp losses. Moving into a position too early or exiting too late are notable risks of momentum investing.

Momentum Investing in Indian Markets

The S & P BSE Momentum index is designed to measure the performance of the 30 companies in the S & P BSE Large Mid-Cap that exhibit the most persistence in their relative performance, measured by their risk-adjusted price momentum score. The index was launched on December 3, 2015. Since inception, the BSE Momentum index has consistently outperformed BSE Sensex and stands as a testament that momentum investing has helped investors beat market returns and gain more wealth. Due to its constant outperformance, more investors are being captivated towards the art of momentum investing. Globally, momentum investing has enjoyed a strong run for many years with cracks only showing when the stock markets went into a tailspin as experienced in the years 2000, 2008 and 2020.

There are various ways of implementing a momentum investing strategy. One of them involves a set of rules aimed at investing in the best-performing stocks over the past one year for the subsequent six months or one year. On the same lines, an investor can also short-sell the worst performers from the past six months for the next six months. To see whether momentum investment strategies have really worked in the past, we have extracted data for two popular benchmark indices, namely, BSE Small-Cap index and BSE 500. We have pulled out the data of the top 20 gainers and losers of the particular indices over the last 10 years and taken an average of the same.

Comparing the returns given by a set of stocks in a particular year with the returns given by the same set of stocks six months and 12 months in the next year will help us understand whether momentum investing really works wonders. For instance, if we look at the BSE Small-Cap index’s top 20 gainers’ table presented here, in the year 2010 the top 20 gainers have delivered average returns of 100.31 per cent whereas on an average the same set of stocks have gained 34.49 per cent in the next six months i.e. the first six months of 2012 and 152.89 per cent in the next 12 months i.e. the entire year 2012. This indicates that if an investor exits from a stock at the end of 2011 with a view that it has already gained much, he will be deprived of the further gain he could have bagged by holding the stock.

The top 20 losers’ data also indicates that holding the stocks which have given returns in negative territory also have turned the tables for investors in the next six months and 12 months. The strategies of momentum investing have been seeing outperforming in the bull phase of domestic markets. Amongst the data presented here, the years 2014 and 2017 to 2020 have been bullish for the equity markets and the momentum investment strategies have clearly outperformed the other strategies, making investors believe more in applying them.

 

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