Stocks and mutual funds experience momentum—meaning that recent performance tends to persist. A stock or a fund that is doing well lately tends to continue to well in the coming months or even years.
Momentum investing strategies, like our own Upgrading approach, attempt to take advantage of this by investing in funds that have strong recent returns and avoiding funds with weak returns.
Many investors like the idea of momentum investing, but they let common misconceptions hold them back.
They assume that momentum hasn’t been around long enough, or that trading costs and taxes will eat into any potential gains. But a May 2014 paper, “Fact, Fiction, and Momentum Investing” by a group from AQR Capital and the University of Chicago, as well as our own nearly 50-year experience, debunk these common myths.
Myth #1: Momentum investing is new.
Fact: Momentum has a much longer history than most investors realize.
Momentum investing may be unconventional, but it’s not new.
The study, “Fact, Fiction, and Momentum Investing”, noted that
“The existence of momentum is a well-established empirical fact. The return premium is evident in 212 years (yes, this is not a typo, two hundred and twelve years of data from 1801 to 2012) of U.S. equity data….Some of this evidence predates academic research in financial economics, suggesting that the momentum premium has been a part of markets since their very existence, well before researchers studied them as a science.”
Momentum doesn’t only work in studies. Our own Upgrading approach has an independently verified, real world track record that goes back to 1980.
Myth #2: Any gains from momentum will be eaten up by trading costs.
Fact: Momentum investing overcomes trading costs.
All investors have to consider trading costs because these costs eat into their returns. But today, these costs are often nominal. Many funds are available without transaction fees and fewer funds charge redemption fees.
“Fact, Fiction and Momentum Investing” found that costs could be overcome by excess returns.
The authors put this to the test “using a unique dataset containing more than a trillion dollars of live trades from 1998-2013 across 19 developed equity markets.” they found that “per dollar trading costs for momentum are quite low, and thus, despite higher turnover, momentum easily survives transaction costs.”
Myth #3: Momentum investing isn’t tax efficient.
Fact: Momentum investing can be “tax advantageous”.
Perhaps the most common myth about momentum investing is related to taxes. Momentum strategies tend to have higher turnover than other popular investment approaches, but “Fact, Fiction and Momentum Investing” confirms that “high turnover does not necessarily equal high taxes.”
In fact, the authors found that “momentum actually has turnover that is biased to be tax advantageous—it tends to hold on to winners and sell losers—thus avoiding realizing short-term capital gains in favor of long-term capital gains and realizing short-term capital losses. From a tax perspective this is efficient and effectively lowers the tax burden of momentum strategies.”
Myth #4: Momentum always outperforms.
Fact: Momentum has a good track record, but it doesn’t always beat the market.
No investment approach succeeds in every market environment, and momentum strategies are no different.
Mark Hulbert reported that NoLoad FundX is “the best-performing momentum strategy over the long term”, and he also added, “needless to say, this strategy doesn’t beat the market every year.”
“Fact, Fiction and Momentum Investing” found the same is true for all momentum approaches. “We make no claim that momentum works all the time,” the authors wrote, but it has “an impressive long-term average return that survives all the attacks (myths) hurled against it.”