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Riding the Big Wave: Momentum Investing

Momentum investors, who trade on the theory that high-performing stocks continue to soar for a period of time, have a lot in common with big wave surfers. Both often incur high costs in search of riding the "big wave," and both have a greater chance of wiping out when the wave gets the best of them.

Momentum investing has characteristics in common with high energy surfers, those individuals who search the world every year to find the tallest, most powerful waves to conquer. It might be Australia, South Africa, Hawaii or another location, or even several of them over the course of a year. Though all these places take time and money to visit, a serious sports enthusiast might think that she is rewarded sufficiently with a soaring ride. She could even sing a “high C” while enjoying her trajectory. However, having an accident or worse during the process could sour her.

Like big wave surfing, momentum investing is based on the supposition that high-performing stocks continue to soar for an indeterminate period of time. It also assumes that those in the lowest-performance stratum have a tendency to stay that way for a while. This thinking gives investment managers an opportunity to capitalize on the top 20% high-performing stocks, and thereby hopefully achieve outsize performance analogous to the big wave surfers.

This concept is based on work by Elroy Dimson, Paul Marsh and Michael Staunton of the London Business School. In 2010, they published the "Credit Suisse Global Investment Returns Sourcebook." The researchers demonstrated that the top 20% of U.K. equities (the winners) returned an average of ₤2.3 million from 1900, compared with the lowest 20% (the losers) that returned an average of just 49 pence. Each stock began with one pound in 1900.

A similar study was carried out on the U.S. stock market 1927-2008 by the hedge fund AQR Capital Management. It found that American stocks with the highest momentum -- or the annual return in subsequent 12 months based on momentum in previous year in percent -- outperformed those with the poorest momentum by more than 10 percentage points a year. This resulted in AQR initiating funds that endeavor to successfully use the momentum strategy.

A good critique of the momentum trading method is this article in the January 15th issue of The Economist. One big downside is high trading costs. This is analogous to the surfer who searches the world for the best beaches and thereby has the high expense of traveling and time to consider. A fund manager, likewise, in an effort to keep up with winners, might change the components of these categories monthly, or even within a shorter time frame. This frequent buying and selling incurs expense, which is a drag on the return.

Warren Buffet too seems not to favor this approach, saying, “The investor of today does not profit from yesterday's growth.” The Australian Independent Financial Advisors have a short piece on the web explaining why they believe Buffet said this.

Among the other concerns regarding momentum investing is risk, since higher return stocks are generally in this category. This means they have a greater chance of wiping out like the danger-seeking surfer. This caution reminds me of the advertisements for most mutual funds, “Past performance is not indicative of future performance.” This concept is based on the respected efficient market hypothesis, meaning that a future share price can’t be foreseen by the past. Now, it seems some segments of the investment industry are singing a different tune. Their “high C” is momentum investing. The only question is whether it will go flat.

As a footnote, other momentum funds have been in existence longer than the recently initiated AQR group. One that uses this technique in moderation is Turner Midcap Growth Investor (TMGFX). It is conservative compared to aggressive momentum funds that turn over a portfolio frequently. Turner Midcap Growth has a more modest 90% turnover, suggesting that the stocks are replaced no more than once every year. When compared with the performance of the NASDAQ stock market index or Standard & Poor’s 500-stock index, it is superior over the last 12 years. Its lows were less low and its highs were higher. This is optimistic for at least one such fund, run in such a way that trading costs are less likely to eat up profit.

The 12 year performance chart of TMGFX in blue compared to the S&P 500 index in green and the NASDAQ index in red.

This information and content is offered for informative and educational purposes only. MyMoneyMD, LLC is not acting as a Registered Investment Advisor, Investment Counsel, Tax Advisor, or Legal Advisor.

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