Factor Commentary

Busting 3 common myths about momentum investing

Jul 21, 2016

 

If you’ve been tempted to pile in on a hot stock blazing on an upward trend, you were contemplating momentum investing.

 


Momentum investing follows upward price trends in a systematic way. This strategy is based on the concept that winning stocks continue winning and losing stocks continue losing. As such, it tends to work best in upward or downward trending markets. Following price trends also means that momentum strategies can make for a bumpy ride, since reversals can be painful when they occur. But for investors who can stomach the volatility, momentum strategies have paid off in the long-term, outperforming the market by 3% on an annualized basis.

Momentum winners and losers returns vs. the market

Cummulative Returns

The above returns are for illustrative purposes only and not based on a portfolio BlackRock manages. The data is fromKenneth French’s data library and stretch from 1927-2015. http://mba.tuck.dartmouth.edu/pages/faculty/ken.french/data_library.html
The “market” is defined by the Fama/French benchmark portfolios. To find winners and losers, the database for momentum stocks has been sorted by decile. “Winners” represent an average of the top 50% of decile returns and “losers” represent the average return of the bottom 50% of decile returns. Index and hypothetical portfolios are unmanaged, are not investable, and returns are for illustrative purposes only, and do not reflect any management fees, transaction costs or expenses. Past performance does not guarantee future results. Returns do not represent actual iShares Fund performance.

Myth 1: All momentum strategies work the same way.

Reality: How momentum strategies are implemented can materially impact performance. The textbook academic approach looks for high momentum stocks by sorting cumulative stock returns over a 12-month period. When we deploy this investment strategy in the real world, we’re able to refine and improve upon this approach.

Risk-adjusted excess returns

Our preference is to identify trends based on risk-adjusted excess returns – a measure of how much risk is involved in producing that return – or mathematically, the investment return above the risk-free-rate^, divided by its volatility. Using risk-adjusted excess returns allows us to assess stock performance on an even playing field of risk.

Our method builds on the textbook approach – which sorts stocks by cumulative returns. Using cumulative returns doesn’t adjust for the riskiness of a stock, so more volatile companies can disproportionately drive the results.

6 and 12-month horizons

While the academic research points to 12-month periods for measuring momentum, in practice we can actually increase the frequency of measurement while managing for transaction costs. We believe that selecting stocks based on both 6 and 12-month horizons can help capture securities that are trending more consistently than those exhibiting trends on an annual basis.

Myth 2: It is impossible to directly capture momentum, largely due to transaction costs and tax inefficiencies.

Reality: Momentum strategies, particularly in ETF form, have posted above-market returns with minimal transaction costs. In 2014, the iShares Edge MSCI USA Momentum Factor ETF (MTUM) outperformed the S&P 500 by 0.8% with 123% turnover. In 2015, MTUM outperformed the S&P 500 by 7.7% with 140% turnover. In both years, transaction costs within the fund totaled 0.01%. MTUM has never paid out a capital gain.*

Myth 3: A momentum ETF cannot move quickly in response to market events

Reality: Index-based products can also be designed to react to market events. MTUM tracks an index that rebalances twice a year, but the index also builds in contingent rebalancing when market volatility spikes –as it did in August 2015.