top of page
  • Writer's pictureDex

Momentum



The momentum factor is based on the idea that stocks that have recently performed well tend to continue to outperform those that have performed poorly. This phenomenon, known as trend-following, is widely used by both professional and retail investors and is intuitive to many people.


In the aftermath of the global financial crisis, central banks implemented large-scale quantitative easing (QE) campaigns, which inflated asset prices across the board. This led to a trend-following strategy of going long equities and long bonds performing well, as both markets saw significant rallies.

Momentum can also be observed at the sector level. For example, the technology sector has seen strong performance since 2010, which can be attributed to both fundamental shifts in productivity and usage and a fear of missing out as the sector's winners became even bigger winners, leading to a self-fulfilling prophecy in terms of price action.


Reasons for momentum


There are several reasons why the momentum factor may exist. One reason is that traditional stock investors are human and exhibit human behaviors and patterns. Quantitative investment firms have identified these behaviors and developed trading signals based on them, classifying the momentum premium as a legitimate style factor. Some general reasons why the momentum factor may exist include:


  • Anchoring bias: Investors tend to anchor their views of a stock's value to its past performance or the price they paid for it, leading to a persistence in returns

  • Disposition effect: Investors are more likely to hold onto losing stocks for too long and sell winning stocks too early, leading to a momentum in returns

  • Herding behavior: Investors may follow the actions of others, leading to a momentum in the direction of the market

  • Information asymmetry: Some investors may have access to better information or be quicker to act on it, leading to a momentum in returns for those with an informational advantage

  • Psychological biases: Investors may be swayed by their own emotions or cognitive biases, leading to a momentum in returns based on irrational behavior.


The momentum factor is based on the idea that stocks with strong historical returns tend to continue to outperform those with weaker returns. This pattern can be quantified by analyzing past performance and identifying which stocks have performed the best. Both academics and quantitative firms have used this approach to define the momentum factor.

The momentum factor is often constructed by ranking stocks based on their past returns and selecting those with the highest returns to be included in the portfolio. This approach is designed to capture the persistence of returns that is often observed in financial markets. However, it is important to note that past performance is not necessarily indicative of future performance, and there are no guarantees that the momentum factor will continue to be successful in the future.


The momentum factor tends to have higher volatility compared to other style factors, such as value and quality. This is because it is closely tied to the overall market index, and the market as a whole is generally more volatile than individual stocks or sectors. In general, the long-short momentum factor has had a 1-year rolling volatility of around 13% since 2010. However, this volatility increased significantly during the COVID-19 pandemic in 2020, reaching around 35%. After the Federal Reserve turned on the stimulus, the volatility of momentum sharply declined back to its average level. It is important to note that past performance is not necessarily indicative of future performance, and investors should carefully consider the risks and potential rewards of any investment strategy.



The graph above compares the rolling 1-year volatility of the momentum factor to other style factors, such as value (hml) and quality. Since the COVID-19 pandemic in 2020, both value and momentum have had structurally higher volatility than quality. It is important to note that past performance is not necessarily indicative of future performance, and investors should carefully consider the risks and potential rewards of any investment strategy. It is also worth noting that different factors may perform better in different market environments, and it is important to diversify a portfolio in order to manage risk.


Correlation of the long-short momentum factor to other Fama-French style factors such as value (hml), size(smb) and momentum (mom), based on a 2 year lookback window



The momentum factor is negatively correlated with the value factor, which is generally consistent with the idea that momentum represents recent winners and value represents cheap stocks. However, the relationship between the momentum factor and the quality factor is not as straightforward. In general, one might expect strong companies with good performance to build market share and continue performing well, leading to a positive relationship between momentum and quality. However, these relationships can change over time, and currently, the correlation between momentum and quality is close to zero and could potentially go negative. It is important to note that the correlations between different factors can vary over time and are not always stable. Investors should carefully consider the risks and potential rewards of any investment strategy and diversify their portfolio in order to manage risk.


January Effect


It is worth noting that the "January effect" is a well-known phenomenon in the financial markets, where stocks tend to outperform in the month of January, particularly small-cap stocks. Some researchers have suggested that this effect is due to tax-loss selling, where investors sell underperforming stocks at the end of the year to offset capital gains and reduce their tax liability. Others have suggested that the January effect is due to a mean-reversion tendency in the markets, where underperforming stocks tend to catch up with the overall market. However, it is important to note that the empirical evidence for the January effect is mixed, and it is not a guaranteed phenomenon. It is also worth noting that the impact of the January effect on the momentum factor specifically has not been extensively studied, and it is not clear if the January effect has a significant impact on the momentum factor.


Momentum factor performance against other Fama-French style factors, time period 2010-2022


Overall, the momentum factor has shown consistent performance across time and geography. It tends to do well in environments where there is a consistent theme and volatility is relatively contained, as this allows for the status quo to continue and past winners to keep performing well. However, it is important to note that no investment strategy is risk-free and past performance is not necessarily indicative of future results. Investors should carefully consider their investment goals and risk tolerance before making any investment decisions. It is also important to diversify one's portfolio in order to manage risk.



However, momentum has been widely studied and recognized in the field of finance and investment as a valid factor that can affect the performance of investments. Research has consistently shown that stocks that have recently performed well tend to continue to outperform those that have recently underperformed, at least in the short-term. This is known as the momentum effect and it has been observed in various asset classes and markets around the world.


While the exact mechanisms behind the momentum effect are still not fully understood, it is generally believed to be related to investor behavior. Some theories suggest that investors may be more likely to invest in stocks that have recently performed well, either due to a belief that they will continue to do well or due to the psychological appeal of investing in winners. This increased demand can then drive the prices of these stocks up, leading to further outperformance.


To summarize, while the momentum factor may not be fully understood, it is widely recognized as a valid factor that can affect the performance of investments and has been incorporated into many investment strategies.


2 views0 comments

Recent Posts

See All

Size

Comments


Commenting has been turned off.
bottom of page