Does momentum investing work and is it right for your portfolio?

15 min Read Published: 09 Jul 2018

Does momentum investing workBeyond the basic growth versus value divide, there are many different investment styles and strategies for a DIY investor to choose from. When you’re trying to build a portfolio that works, it can seem like a confusing array of ideas competing for your attention. But there is one strategy you could consider which is tried and tested and shown to work consistently over the long term, contrary to what you might expect. This is momentum investing.

What is momentum investing?

Momentum investing essentially means tapping into a stock or asset where the price is trending upwards. It’s a bit like allowing the rising tide to lift your boat – investors hope to profit from a current positive trend in the marketplace that they think will continue doing well. It also works the other way, momentum investors are more likely to sell a falling stock. But isn’t this just the same thing as following the herd, something we are told not to do when it comes to investing? Yes, but rather than just going with the crowd, a momentum investor wants to take advantage of other people’s fear of missing out, which makes them chase returns by piling into something that is going up, further inflating its price. But momentum investors will be trying to buy high and sell higher, getting out before a stock starts to lose momentum.

Studies have shown that momentum investing does work (for more on this, see the section below on Performance). And there are many famous momentum investors who have made their fortunes by following this approach. Richard Driehaus, for example, is a well known American investor and philanthropist who is often credited as the ‘father of momentum investing’. He has said his philosophy is to buy stocks he is confident can head higher, rather than just buying something which is cheap and hoping for a turnaround (the latter is known as value investing). Momentum investing delivered a reported 30% compound return a year for his firm in the 12 years after it was set up in the 1980s.

How does momentum investing work?

Momentum investing means buying the best performing assets from recent history that have an increased likelihood of continuing to rise. Let’s examine how it might work as a strategy in a bit more detail. Instead of buying an index tracking fund or just one active fund and then holding it for years, you would switch your cash into the current best performing fund (or stock if you trade individual shares) at regular intervals – say, every three, six or 12 months. Your aim is to sell before the asset loses momentum, and then buy the next asset/fund that’s currently going up.

If you’re convinced about the potential in momentum investing and want to give it a try, you might be wondering what’s the best momentum strategy to use? It’s quite a lot of work to monitor the market yourself for trending stocks and making sure you know the right time to buy and to take profits  A sensible strategy, then, might be momentum investing using funds, whether active or passive. For more on this, see the section below on Momentum investing with funds.

Momentum investing performance

Numerous academic studies support the case for momentum investing. One paper points to a momentum return premium in UK equity data which dates back to the Victorian age.

Another found that stocks which showed positive momentum over six months and which were then held for the next six months returned a compound annual growth rate of 12%, beating the S&P 500’s average 10% a year return. The researchers concluded that “strategies which buy stocks that have performed well in the past and sell stocks that have performed poorly in the past generate significant positive returns over three- to 12-month holding periods.”

A recent study from Queen Mary University’s business school found that investment strategies which combine momentum with leverage result in almost double the yield than other strategies. It found this method of buying winning stocks using a momentum approach and shorting losers could return 16% a year. But of course, leverage (investing with borrowed money) is a tool that should always be handled extremely carefully and is not for novice investors.

We conducted our own research to see how much momentum investing could add to returns based on a £10,000 fund portfolio invested in UK equity funds back in 1995. If you had invested that money in the FTSE 100 for the next 19 years, your pot would have been worth £33,428. If you had put it into a typical UK equity fund, you would have been sitting on £35,235 after 19 years. But if you had used a momentum approach to picking UK equity funds, switching funds every three months to buy the best performer, your portfolio would be worth £114,057, an incredible difference from switching funds just four times in a year. Our 80-20 Investor service can help investors apply momentum in this way when investing via funds as it provides fund shortlists based upon a momentum algorithm. If you click on the link you will also see a performance chart showing how the 80-20 Investor selection process has fared since launch in August 2014.

Myths surrounding momentum investing

There are a few persistent myths about momentum investing which we can now examine and debunk.

  • ‘Momentum only works for short sellers.’

This research paper shows that there is little difference between the long and short sides of momentum, it’s actually an even split as they are as profitable as each other.

  • ‘Momentum only works for small-cap stocks.’

Not true, in fact it’s the value approach that tends to work better among small caps where the value premium is strong compared to large caps. A paper by Israel and Moskowitz (2013) found no evidence that momentum is related to size.

  • ‘Momentum investing leads to higher trading costs which outweigh any gains.’

One study analysed real world trading costs for a big institutional investor in relation to momentum, value and size-based strategies and found that momentum easily survives transaction costs. It is true that momentum is a higher turnover strategy, so retail investors who do not have the economies of scale an institutional investor enjoys should choose a competitive trading platform so they are not paying over the odds on trading costs. Nowadays most fund platforms do not charge anything to switch funds.

  • ‘Momentum is not a serious investment approach, it’s just following the herd.’

Studies suggest that momentum as a strategy is surprisingly stable. Although it may not work all the time, proponents argue that it boasts an impressive success rate over the long term and can make a big difference to overall returns.

The risks of momentum investing

No investment strategy is without risk. One of the big questions posed to fans of momentum investing is ‘at what point does momentum become mania?’. The dotcom boom and bust was a good example of how investors can get carried away following the latest trend, only for it to end in disaster. One of the biggest problems with momentum investing is that it can go both ways – momentum can be positive or negative. This means it can be a volatile strategy which can amplify losses in a downturn. For this reason, 80-20 Investor uses trailing stop losses which act as an early warning system to let you know when it might be time to sell a position.

Another issue is that a momentum strategy requires more of your attention that a simple buy and hold approach, you need to keep an eye on marketplace trends, and not everyone will have the time or inclination to do this. 80-20 Investor can help with this too.

Momentum investing vs value investing

Probably the world’s most recognisable investor is Warren Buffett, a famous figurehead of value investing. His incredible success using a value approach often leads people to claim that value investing is better than momentum investment strategies. Buffett’s method is to scrutinise company balance sheets and accounts to identify factors the wider market can’t see, reasons why a stock can perform better than most analysts expect and therefore why it looks undervalued. This is difficult for the average DIY investor to achieve without the resources of a multi-billion dollar company’s research department behind them. The market is full of investors who misread the signs and paid the price by falling into a value trap, and even Buffett himself sometimes gets it wrong. For most DIY investors, it’s a lot easier to follow momentum.

Momentum investing with funds

You can buy specific investment products that follow a momentum strategy while targeting different regional markets. There are a few exchange-traded funds on the market which explicitly follow momentum strategies, for example. ETF momentum investing might see you holding vehicles like the iShares Edge MSCI World Momentum Factor UCITS ETF or the Vanguard Global Momentum Factor UCITS ETF. iShares also has US and Europe-focused momentum ETFs.

It’s much harder to find momentum funds to choose from amongst active funds. Active fund managers will not often admit to using momentum investing, but will instead say they are buy and hold investors. They may view a momentum strategy as too short term, and say they never try to time the market. Rather than chase returns by following trending stocks, they argue they will only invest after carefully researching a business’s fundamentals. But, in reality, they are probably using momentum in some ways. For example, fund managers will often look for earnings momentum, which is based on the idea that companies that have beaten analysts’ earnings forecasts once will do so again.

If you’d rather build your own fund portfolio, which enables you to manage risk and diversify, using a momentum based strategy our 80-20 Investor empowers investors to do just that. With weekly updated fund shortlists its unique algorithm identifies those funds with the greatest momentum. The services also provides unique research on all aspects of investing, not just momentum. Have you ever wondered whether you should invest all your money at once or drip it into the market over time? Or which funds can make money in a falling market? 80-20 Investor's research articles tell you the answer.

I also successfully run £50,000 of my own money live on the site to show how simple it is. 80-20 Investor helps you to simply decide the funds to invest in via your existing fund platform. Find out more about how the service works and take advantage of a 30 day FREE trial.

Alternatively, if you would like to learn more about how to choose the best funds to invest in for the current environment our short email series How to become a successful DIY investor explains it in more detail.