Momentum investing is having an Edgar Allan Poe moment. It has been declared dead – or at least mostly dead – and buried. But a revival befitting a macabre tale is almost inevitable.
Before knocking on momentum’s coffin, it’s important to know how it got there. Mark Hulbert made the case against momentum in a recent Wall Street Journal article and shot it right in its performance.
Mr. Hulbert highlights the problem with momentum using a monthly rebalanced portfolio that owns the 10 per cent of U.S. stocks with the highest returns over the prior year, which is simultaneously short the 10 per cent of stocks with the lowest returns over the same period. The portfolio gained an average of 17.4 per cent annually from 1940 to mid-2002. The same portfolio declined by an average of about 3.6 per cent annually since then. By way of comparison, the stock market gained an average of 11.4 per cent annually in the early period and 10.4 per cent annually in the latter. (The returns herein are presented in U.S. dollar terms but do not include transaction costs.)
The recent returns suggest that momentum died in the U.S. in the early years of this century. Mr. Hulbert points to a study of changes in Morningstar’s (MORN) fund ratings that might account for a good part of momentum’s demise.
Morningstar stopped rating funds primarily on their trailing returns in mid-2002 and began comparing funds to those with the same investment styles. The move is sensible because the approach now compares, say, a small-cap growth fund to other small-cap growth funds rather than to all funds.
Morningstar’s change prompted its followers to move money into a more diversified selection of funds rather than just pouring cash into the hottest funds of the day that in turn held some of the hottest stocks. Moving to a more diversified approach removed some of the buying pressure on hot stocks and dealt a blow to momentum as the market adjusted.
The argument is interesting, but incomplete. The problem is, momentum can be found outside the U.S., in the distant past, and in more modern times before Morningstar started rating funds in the mid-1980s. It can also be found across a plethora of asset classes.
Nonetheless, Mr. Hulbert’s thesis is worthy of consideration and likely represents one of many factors that impact momentum investors.
It also provides the opportunity to check in on momentum as it applies to “long-only” investors. That is, to see how it has done for momentum investors who simply buy recent winners while avoiding the laggards.
To get a handle on the numbers, I turn to Professor Kenneth R. French’s data library. In one study he splits the U.S. stock market five ways (quintiles) by size (market capitalization) and then five ways by momentum, which results in 25 portfolios. The portfolios are equally weighted, rebalanced monthly, and momentum is measured using returns over the prior 2-to-12 months (i.e., skipping the most recent month.)
The accompanying table shows the average annual total returns of each portfolio from the start of 1940 to the end of October, 2023. For instance, the portfolio following the 20 per cent of highest momentum stocks among the 20 per cent of largest stocks in the U.S. gained an average of 14.7 per cent annually.
You’ll notice that the long-term returns almost uniformly increase as momentum climbs and size declines. Similar results for the last 20 years (not shown) are much flatter, although the lowest momentum stocks continued to fare relatively poorly while the highest momentum stocks trailed the middle groups.
The accompanying graph highlights momentum’s recent malaise. It shows the rolling 10-year average returns of the portfolio with the highest momentum and largest stocks while including a market portfolio that tracks the largest 20 per cent of stocks and is weighted by size. Each point on the graph represents returns over the next 10 years. It begins on the left with the 10-year period from the start of 1927 to the start of 1937. It ends on the right with the 10-year period from the end of October, 2013, to end of October, 2023.
You’ll notice that the momentum portfolio beat the market for most of the rolling 10-year periods. But it ran into trouble in the early 1930s when it generally fared poorly and also lagged the market on occasion. It fared well in the early 1980s, but the market also provided similar results. The market proved to be competitive in the decade starting just before the crash of 2008-09 through to more recent times. As a result, investors shouldn’t expect it to outperform all the time.
It strikes me that momentum encountered two huge market declines in the last 25 years and it’s amazing it held up as well as it did. Time will tell if it’s a dead factor or if it’s just resting. My bet is on premature burial.
Norman Rothery, PhD, CFA, is the founder of StingyInvestor.com.
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Norman Rothery