3 Myths to Ditch About Momentum Investing

The financial crisis of 2008 was a baptism by fire for new investors. From 2009 through present day, momentum investing was on the minds of Wall Street’s veteran and amateur investors alike. Yet, while the Dow Jones Industrial Average soared 200%-plus from the lows of the crisis, cracks in the logic of momentum investing began to appear.

3 Myths to Ditch About Momentum Investing

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Boiled down, momentum investing (cutely dubbed “momo” investing) is the practice of going long factors that have outperformed the market over the previous 3 to 12 months and shorting factors that underperformed. Easy, right? But on Nov. 21, 2018, Money Maven’s Sean Hyman drills into the logic behind momo stocks — claiming momentum stocks are dangerous.

Hyman illustrates his point by citing Nvidia (NASDAQ:NVDA). At the time, NVDA had given back roughly 50% of its gains, falling from $292.76 to $149.08.

“My advice,” begins Sean, “would be to stay away from NVDA and other momentum stocks because they’re all ripe for a massive fall.” Since that article’s publication, NVDA has risen 20.6%. But over the past three years, Nvidia’s stock climbed 169.2%, outperforming the iShares PHLX Semiconductor ETF’s (NASDAQ:SOXX) 96.9% rise. Rewind five years, and the gap is even more pronounced — 798.9% vs. 144.8%, respectively.

When you look at it from that perspective, a 50% loss isn’t so significant, is it?

Now, I’m not advocating investors ignore fundamentals and focus solely on a factor’s past performance — I’m just stating the facts about momentum investing. In “Fact, Fiction and Momentum Investing,” authors Clifford S. Asness, Andrea Frazzini, Ronen Israel and Tobias J. Moskowitz identify several “myths” about momentum investing that have been propagated for years.

The Top Three Myths About Momentum Investing

Returns are Volatile and Inconsistent: One of the biggest criticisms against “momo” investing is that returns are too inconsistent. Or, more specifically, gains happen in short bursts and periods of losses are extended. If we randomly opened the stock chart of Aurora (NYSE:ACB) to Feb. 19, 2019 through March 20, 2019, we’d see a burst of roughly 41% … but over the next six months, ACB stock gives back all of those gains. However, historical data disproves the notion that momentum investing is somehow sporadic. From SSRN:

“Momentum’s presence and robustness are remarkably stable (and by this we don’t mean that it doesn’t have long stretches of poor performance, as does any factor, or short stretches of extreme performance; we mean the overall evidence across very long periods of time and in many places).”

To this point, Professor Kenneth French provides data that can be replicated by any investor.

Despite exhibiting higher-than-average volatility, French’s results show that momentum investing provides an overall stable set of returns. Importantly, the conclusion drawn from this research is not to invest in momentum stocks alone, but to use momo in conjunction with value investing.

Interestingly enough, research released earlier this year from finance professors Sina Ehsani of Northern Illinois University and Juhani Linnainmaa of the University of Sourthern California optimized the momentum investing approach. What they uncovered, essentially, is that you can invest in momentum by betting on the best-performing factors of the previous year, as opposed to betting on individual stock performance.

The Wall Street Journal illustrates how this would work in a real-life portfolio, suggesting that investors break their portfolios down by market capitalization and compare performance. Since large caps beat small caps (the DJIA vs the Russell 2000), this momentum approach would bet on large-cap stocks. Next, investors rebalance their portfolio by comparing exchange-traded fund performance (this enables them to hone in on the next factor to prioritize) against the broader market. Then, invest in the factors that beat the market over the past year.

Momentum Is for Small-Cap Stocks Only: As a financial journalist and editor, I’ve seen headlines of this sort almost on the daily. “Invest in this Small Cap for 5,000%+ Returns!” or “Go Small for BIG Gains.” And while it’s not necessarily false, it’s misleading at best and malicious at worst. The myth that small-cap stocks are a momentum investor’s best bet was created in the early aughts after a paper researched returns of small stocks, finding they often outpaced their large peers. The paper never stated, however, that large caps are incapable of providing similar momentum.

Quite the opposite.

Large-cap stocks, according to the researchers, are equally capable as small caps of momentum performance. The paper points to research from Kenneth French, cited above, that tests the returns of a small-cap portfolio long winners and short losers against a similarly composed large-cap portfolio. The results show that between 1913 and 2013, the small portfolio averaged 9.8%, while the large group averaged 6.8% — not a big difference once you factor in increased risk and volatility for small stocks.

Interestingly, the value proposition for large stocks dropped significantly. As the researchers put it, “… to argue that momentum is all about small stocks is completely inconsistent with the facts, and far more of an argument to lay at the feet of pure value investing. To promote this myth about momentum while simultaneously advocating value investing is bordering on absurd.”

Trading Costs Nullify Momentum Gains: According to this myth, the premium to finance a momentum strategy (of potentially shorting small stocks) outweighs the gains. The analysis details real-world data compiled by Frazzini, Israel and Moskowitz to model transaction costs of trillions of dollars in trades over a period of 15 years. These data span 19 developed markets, concluding that “per dollar trading costs for momentum are quite low, and thus, despite the higher turnover, momentum easily survives transaction costs.”

The myth, the paper states, comes from fallacious studies that use aggregated data to measure costs for the average investor across all trades, rather than measuring institutional costs. The costs for an individual are ten times higher than those of institutional investors.

“Since the premium for momentum is much higher than it is for size, and the costs to trading momentum are slightly lower than those for size (momentum is higher turnover but small caps are more expensive to trade than other stocks), you don’t have to do much math to realize that momentum can easily survive trading costs.”

You can read the full report dispelling myths about momentum investing here.

However, investing for momentum is only one part of a well-rounded portfolio. After all, there are plenty of little-known companies that are “keystones” to fundamental technologies that will change our lives.

One little development, a slight perspective tweak, could become a driving force at the intersection of technology and humanities. Much in the way the iPhone has permanently sewn digital interaction into daily life. Diving deeper, the iPhone’s revolutionary execution was only made possible by a keystone technology — 3G. The next technological evolution will be made possible by a natural succession of next-generation keystone applications. To learn more, read legendary tech investor Matt McCall’s treatise on the technology that will facilitate the next big breakthrough of our generation.

John Kilhefner is the managing editor of InvestorPlace.com. As of this writing, he did not hold a position in any of the aforementioned securities.

Article printed from InvestorPlace Media, https://investorplace.com/2019/09/myths-momentum-investing/.

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