Momentum investing: How it works

Momentum investing has long confounded the investment community. It is predicated on the idea that securities or funds that have performed well can continue to outperform, and those that are doing badly will continue to disappoint. Effectively, investors seek to profit from the momentum behind a trend that they have identified in the stockmarket.

"True momentum investors only want to buy into an idea when they think there is momentum behind it. There are obvious derivations of momentum investing. For example, some people use a combination of momentum and earnings upgrades, which can go hand in hand," notes Julian Chillingworth, chief investment officer at Rathbones.

This style of investing has gained a bad reputation through time, because investors have lost substantial sums after buying into stockmarket bubbles that burst. After all, what goes up has to come down. "Momentum unwinds quickly, so if you get downward momentum it means you are selling into a fall," Chillingworth adds.

Shunning 'buy and hold'

The idea of successfully profiting from momentum in the stockmarket over the short term also flies in the face of the "buy and hold" approach that many fund managers espouse. Warren Buffett, known as the Sage of Omaha, is one of the most vociferous advocates of this latter investment style.

In his opinion, amongst others, the best and simplest way to make money is to target investments that look undervalued and hold them over a long timeframe - until that value is realised. In the meantime, "buy and hold" investors try to ignore short-term share price movements, in the belief that the longer-term investment case remains intact.

People got their fingers burnt in the dotcom bubble, as rising share prices ignored fundamentals

Gavin Haynes, managing director of wealth manager Whitechurch Securities, prefers to back fund managers who take a value or contrarian investment approach. This involves keeping a keen eye on the underlying valuations of shares and then selectively buying into the "right opportunities at the right price" - even if these are unloved by other investors.

"We prefer taking a more contrarian approach by backing areas that are out of favour and offer recovery potential. The dotcom bubble bursting 15 years ago is a good example, where momentum investors got carried away and people got their fingers burnt, as rising share prices ignored fundamentals and underlying valuations," Haynes explains.

"Momentum investors can be successful, but the opposite can apply when investors get carried away by upward markets and end up buying into areas at the wrong stage in the cycle, based on the strength of previous momentum. The dotcom bubble provided a painful lesson for those who had bought shares at inflated valuations."

Does it work?

If lessons have been learnt from previous stockmarket cycles, can momentum investing actually work in this day and age?

Today, many investors simply use it as a trading tool or as one of multiple screens within an investment process, rather than as the sole criterion that drives all investment decisions.

However, a study published in May 2014, entitled Fact, Fiction and Momentum Investing, by Clifford Asness, Andrea Frazzini, Ronen Isreal and Tobias Moskowitz, has concluded that momentum investing can and should be used successfully as a standalone investment strategy.

You can't be a little bit pregnant: either you believe in momentum and acknowledge the data, or you don't

"Advocates of the 'screen approach' want to find a way to use a little bit of it because of the strong evidence in its favour. The problem is (as the saying goes) 'you can't be a little bit pregnant'. Either you believe in momentum and acknowledge the data, or you don't," the authors observe.

Simply using momentum as a screen rather than as the deciding factor in stock selection is unsatisfactory, in their view, because, they maintain, historic data suggests that momentum works better than other styles. For example, they point to research that suggests momentum achieves better returns in large-caps compared to a value-driven approach.

In reality, momentum investing requires skill and its success is reliant on using up-to-date and accurate information to drive investment decisions. The success of Saltydog Investor's momentum fund portfolio supports this point. The company was set up in late 2010 by three private investors who were unhappy with returns from their respective investment portfolios; they developed a momentum-based system that seeks to take advantage of rising markets and protect investments when markets decline.

They view investment as a continuous relay race, identifying sectors that are flourishing and then choosing the funds performing well from that sector to carry the baton. When a sector runs out of steam, they target the next sector gaining momentum.

The team recommends trading between funds using fund platforms on which investors can switch between funds for free. This dispels another common criticism levelled at momentum strategies: namely, that returns are eroded by the high trading costs that can be racked up.

Salty's best sectors

Saltydog's research is available to subscribers on a weekly basis for a monthly fee of £25 per month. It lists four, 12 and 24-week average returns for key sectors and asset classes in order to help investors work out which sectors and themes to focus on. It then takes the best-performing sectors and identifies the member funds with the best short-term returns.

This is an approach that has paid off so far. As of 9 December, the Tugboat portfolio, which caters for cautious investors, had risen 52.3% since launch in November 2010. What's more, the strategy achieved returns during August, contrasting with many investors who lost money during the summer stockmarket sell-off.

"It is a matter of velocity," says Douglas Chadwick, one of Saltydog's founders. "The greater the amount of money that goes into a fund or sector, the quicker the value will rise. It then acquires impetus on its own and for a time that rise will be self-fulfilling." He acknowledges that the opposite is true when a sector or fund loses momentum and prices fall. That is why timing the switch into new sectors and funds is crucial.

One of the biggest stumbling blocks that momentum investors face is having current and accurate data. Chadwick also advises investors not to fall in love with a particular fund or sector, because this means you are losing sight of the numbers. He says that avoiding forming a strong opinion on the direction of travel for your investments is equally important. "We try not to have an outlook because the moment you have one, you are not using the numbers. This is one of the hardest rules."

If the stockmarket proves to be as volatile this year as it was in 2015, should investors still consider momentum investing?

How does momentum investing compare to other styles? Neptune's chief economist James Dowey points out that the evidence in favour of momentum investing is actually stronger than for other styles such as value or small-cap investing.

Momentum portfolios have also been known to achieve better risk-adjusted returns than others run using value or market-cap specific styles, such as small or large cap. This means that momentum investors have been able to achieve healthy returns but have taken less risk than peers, he adds.

Dowey is not an advocate of using momentum as the sole determinant of investment decisions, however. In his view, it is best used in combination with a value screen. "This is intuitive, because it can help you to avoid both value traps on the one hand and bubbles bursting in your face on the other," he explains.

In addition, value and momentum are factors that are negatively correlated. This combination of value and momentum can help investors to earn better risk-adjusted returns, in Dowey's opinion.

If the stockmarket proves to be as volatile this year as it was in 2015, should investors still consider momentum investing? The evidence suggests momentum investing can work in the right pair of hands, underpinned by up-to-date and accurate information. But only those who are fully committed to the idea should jump on the bandwagon.

This article is for information and discussion purposes only and does not form a recommendation to invest or otherwise. The value of an investment may fall. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.