Momentum is so pervasive that it appears among both individual securities and entire indexes.
A version of this article was published in the September issue of Morningstar ETFInvestornewsletter. Download a complimentary copy of ETFInvestor by visiting the website.
Momentum, the tendency for recent performance to persist in the short term, is one of the most pervasive forces in financial markets. It is difficult to reconcile with the efficient-market hypothesis, which predicts that market prices reflect all publicly available information, including past performance. In fact, Eugene Fama and Ken French, two leading proponents of the efficient-market hypothesis, have called it the premier market anomaly.
There are three potential behavioral biases that could cause momentum: anchoring, disposition, and herding. The first two cause prices to initially adjust to new information more slowly than they should (underreaction), while the third leads to overreaction. Anchoring is based on the idea that investors ground their investment thesis in information they already know and are slow to update their view in response to new information. This phenomenon is consistent with post-earnings-announcement drift, a situation in which firms beat (or miss) earnings expectations, and their stocks pop (or drop) on the day they make that announcement, but continue to outperform (or underperform) during the subsequent several weeks.
The disposition effect describes many investors’ tendency to sell stocks whose prices have increased in order to lock in profits and hold on to stocks that have declined in value in the hope of breaking even, despite changing fundamentals. This behavior is related to loss aversion, where the pain of losing money exceeds the utility from an equal-sized gain. Like anchoring, this can cause prices to adjust more slowly than they should in the face of changing fundamentals, as investors exhibiting this behavior make their trading decisions based on the price that they paid for a security rather than its fundamental value.
Once a trend is established, investors may chase performance and pile into the trade, which could push prices away from fair value (herding behavior). This could lead to the long-term performance reversals associated with the value effect. These long-term reversals make long-term performance-chasing counterproductive.
Momentum is a short-term phenomenon, where relative performance during the past six to 12 months tends to persist over the next several months. Academic studies most commonly measure momentum based on performance during the past 12 months, excluding the most recent one (though the effect persists even without this exclusion), and rebalance monthly.
While investors should arbitrage any predictable pricing pattern away, momentum has persisted more than two decades after it was first widely documented in the academic literature. It is difficult to fully arbitrage because it requires high turnover, which can make the strategy difficult and costly to implement, and it doesn’t always pay off. Simple momentum strategies often don’t work well when volatility picks up, or during sharp market reversals, when performance leadership changes. Just like any other investment strategy, momentum carries its own risks.
Momentum strategies, like iShares Edge MSCI USA Momentum Factor MTUM (0.15% expense ratio), often target individual securities. But momentum also works at the sector, country, and asset-class levels where implementation costs should be lower, as it isn’t necessary to trade as many securities. To illustrate, I tested three momentum strategies using sector, country, and asset-class indexes that investors can gain access to through exchange-traded funds. However, it is important to keep in mind that these are still high-turnover strategies that would be best implemented in tax-advantaged accounts.