Momentum Factor - The Premier Market Anomaly

• Date : July 12,2023

Ever thought about why when you are driving at a high speed and press the brake, the car doesn’t instantly stop, rather it slows down and gradually stops? This phenomenon occurs due to momentum, described by Newton’s 1st law of motion. 

The concept of momentum can be seen in various things in our day-to-day life. Given its wide prevalence, it also has a presence in the stock market. When some stocks in the market rally or have a bull run, they do not stop rising instantly, rather they slow down gradually over a period of time. A similar phenomenon can be observed with falling stocks and during times of a bear market. 

The momentum factor can be categorized as a “persistence” factor due to investing in stocks that have performed well in the recent past and have the tendency to continue performing well in the future. Momentum investors seek to capitalize on this phenomenon by buying stocks that show strong positive performance in recent months. The momentum strategy contradicts the strategy of “buy low and sell high” and rather works on the strategy of buy high and sell higher. 

The momentum factor prevails in the market due to irrational behavioural biases of investors such as herd mentality, fear, greed, representativeness and confirmation bias. Along with other popular strategies like value investing, momentum has also demonstrated exceptional returns in the past. However, momentum tends to be more effective in the short term, and its capacity to influence returns decreases significantly over time. Thus, utilizing momentum may necessitate frequent portfolio rebalancing, resulting in increased portfolio turnover and transaction costs. 

"Momentum investing is not a fad or a trend. It's a legitimate investment strategy that's been shown to work consistently over time." - Charles Rotblut
 

Past Performance:

NJ’s Factor Book data suggests that the 5-year and 10-year rolling returns of the NJ momentum factor portfolio are 19.52% and 17.70% respectively, in contrast to the benchmark Nifty 500 TRI return of 14.47% and 13.42% respectively. 

Source: Internal research, Bloomberg, CMIE, National Stock Exchange of India 

• CAGRs are calculated as the average CAGR based on the rolling CAGRs (rolled daily) calculated for the respective holding periods i.e. 5, and 10-Yr rolling CAGRs. 
• The period for calculation is 30 September 2002 to 31 December 2022. Data scaled to 1000 on 30th September 2002. 
• Past performance may or may not be sustained in the future and is not an indication of future return. 
• The above is only for illustration purposes. Past performance may or may not be sustained in the future. NJ Momentum 100 is a proprietary model developed by NJ Asset Management Private Limited. The methodology will keep evolving with new insights based on ongoing research and will be updated accordingly from time to time. 

 

The Momentum Approaches:

There are two approaches to momentum factor investing :

1. Cross-Sectional Momentum - It is a type of momentum investing strategy that focuses on buying stocks that have performed well relative to their peers. The strategy involves ranking stocks based on their recent returns and selecting those with the highest returns.
2. Time-Series Momentum - Time-series momentum is a type of momentum investing strategy that focuses on buying assets that have exhibited strong positive returns over a recent period of time while avoiding those that have exhibited weak returns over the same period.

Assessing momentum is a crucial aspect of crafting an effective stock selection strategy. However, selecting the appropriate methodology involves several key considerations, including the time period used and the analysis of momentum changes over multiple periods. To make informed decisions, it's important to weigh the advantages and disadvantages of each approach. Ultimately, the methodology should align with the investment objectives and risk profile of the portfolio.

"Momentum investing has been one of the most successful strategies in financial history. It's delivered strong returns with relatively low risk, and it's been able to withstand the test of time." - Jack Schwager
 

Momentum Factor Success Overseas :

Momentum factor investing has gained widespread popularity in foreign markets. The 5-year and 10-year rolling returns of S&P Momentum Index are 8.98% and 8.30% respectively as compared to the 5-year and 10-year rolling returns of S&P 500 of 8.09% and 7.68% respectively. 

Source: S&P Dow Jones Indices LLC

• CAGRs are calculated as the average CAGR based on the rolling CAGRs (rolled daily) calculated for the respective holding periods i.e. 5, and 10-Yr rolling CAGRs. 
• The period for calculation is 5 July 1995 to 31 December 2022. Data scaled to 1000 on 5 July 1995. 
• Past performance may or may not be sustained in the future and is not an indication of future return. 

MSCI's research indicates that the momentum factor has been one of the most effective means of producing alpha historically.

Conclusion:

To summarise, momentum investing is a strategy that has gained popularity in some countries overseas and has started to gain traction in India. While there are ongoing debates about the effectiveness and suitability of momentum investing as a long-term investment strategy, it has been shown to generate abnormal incremental returns in the short term. Overall, while past performance cannot guarantee future results, humans tend to conform to emotional biases leading them to repeat their behaviour. In such a scenario the use of momentum strategies can be a viable option for investors seeking to enhance their returns.

Mutual Fund investments are subject to market risks, read all scheme-related documents carefully.