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The History Of Momentum Investing – Two Centuries Of Pedigree

Posted by: Brian Dennehy
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Retail investors, in funds and otherwise, have been poorly served for far too long. Using a simple momentum process for fund selection solves that problem with huge success, supported by evidence stretching back three decades.  This is the story of how we got there.
 
Ricardo amassed an immense fortune by scrupulous attention to his golden rules:
  • Let your profits run
  • Cut your losses short
 
Ricardo was active in the London markets in the late 1700s and early 1800s, and it was James Grant who made these observations in his book of 1838.
 
Letting your profits run means sticking with what has momentum.
 
Cut your losses means apply a stop-loss.
 
There is nothing new in investing.
 
Richard Wyckoff was personally so successful that he owned nine and a half acres in the Hamptons. He noted that stocks tended to trend and emphasised using stop-losses to help control risk – that was in the first two decades of the 20th century.
 
George Chestnutt said:
 
“It is better to buy the leaders and leave the laggards alone. In the market, as in many other phases of life, the strong get stronger and the weak get weaker.”
 
The market is Darwinian. George ran the very successful American Investors fund from the 1930s using momentum (also called relative strength by some).
 
By the 1980s Richard Driehaus took the momentum torch as a big-name investor. In his interview in Jack Schwager’s The New Market Wizards, he said:
 
“It means buying stocks that have already had good moves – that is, stocks already in demand by other investors. I would much rather invest in a stock that’s increasing in price and take the risk that it may begin to decline than invest in a stock that’s already in a decline and try to guess when it will turn around.”
 
A gentleman called David Ryan also impressed in the 1980s. He won the U.S. Investing Championship in 1985 with a 161% return in one year, came second in 1986 with 160% return and followed that up with another first place finish and yet another triple digit return. Ryan used a momentum strategy and said:
 
“The more disciplined you can get, the better you are going to do.”
 
At its simplest, momentum investing means buying what is going up most today, on the assumption that it will keep going up tomorrow.
 
IMAGINE you are a jockey in the Grand National, and mid-race you can magically switch onto another horse. As your horse visibly runs out of puff, you can jump across to the freshest horse, the horse with greatest momentum.
 
If you could do that, you would win the race wouldn’t you? 
 
Well, it’s the same when investing – except it’s not magic.   Over many decades it has now been shown to be hugely successful, not just by the above-named investors stretching back to the 1700s, but also in academic research.
 
The earliest academic study of which I know is in 1933 by Cowles and Jones. Their work was microscopic, at a stock level, and stretched from 1835 to the 1930s. They were counting the number of times that positive returns were followed by positive returns. Here is one extract:
 
“The probability appeared to be 0.625 that if the market had risen in a given month it would continue to rise in the succeeding month”
 
That might not seem a compelling number to non-statisticians amongst us, but they continued:
 
“The probability of obtaining such a result in a coin-tossing contest is infinitesimal.”
 
Yet, as Corey Hoffstein tells us:
 
“Despite the success of their research on the statistical significance of sequences, the next academic study on momentum was not released for 30 years.”
 
Then it got interesting. 
 
In 1967, Robert Levy published “Relative Strength as a Criterion for Investment Selection”, relative strength being momentum. 
 
Levy found that there was “good correlation between past performance and future performance” over 26-week periods. 6 months momentum – ring any bells?
 
He calculated the extra performance of the top 10% with momentum. On average they went up 9.6 per cent in the 6 months ahead, whereas the bottom 10% went up by just 2.9 per cent i.e. growth by using momentum of 6.7% every 6 months. 
 
But the period he considered was limited – 1960 to 1965 – and this research was not followed up.
 
At this time everyone seemed to be in thrall of the silly idea of efficient markets, which has cost investors fortunes in the decades since.
 
The research all went quiet until 1993, when along came Jegadeesh and Titman with the uninspiring named paper “Returns to Buying Winners and Selling Losers: Implication for Stock Market Efficiency”.
 
“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 3- to 12-month holding periods.”
 
Aha. Now we’re getting there.
 
Momentum research exploded over the next few decades.
 
Rather than bore you with horrible detail, at the end of this blog is a bibliography on momentum from the AQR guys. 
 
As Elroy Dimson and his team put it in 2018:
 
In well-functioning markets, it should not be possible to earn consistently superior returns from the naïve strategy of buying past winners…. Yet there is extensive evidence across time and markets that momentum profits have been large and pervasive. The evidence is so strong that Fama and French, the world’s leading experts on stock returns, describe momentum as the “premier anomaly” – a generous tribute as they were not its discoverers.”
 
Of all the research my favourite was produced by Elroy and team back in 2008, which you should be able to download here, 108 Years Of Momentum Profits, where they state:
 
“Our study of momentum—the first to span more than a century—enables us to speak with more confidence about this phenomenon. The momentum effect has been remarkably persistent. Those who assert it is a chance pattern, or that it was a passing episode, are taking positions that are counter to the evidence. Momentum has been prevalent in stock returns over a very long period.”
 
In parallel, from 2005 to 2012, we were conducting our own research, with a focus on funds. We had no preconceived ideas on what we might find – there were no precedents, not on funds.
 
Our results showed that a 6-month review period worked best, as Levy had identified in 1967, as did many others subsequently, including Dimson et al.
 
Most importantly, the extra performance was huge – this was not an academic exercise, this is all about making your money work a lot harder.
 
The best example (other than the less mainstream Bonkers Portfolio!) is the Dynamic UK Blended Portfolio. This has now grown 13 times more than the index (FTSE 100) since May 2000.
 
On average the extra performance was just over 10% per annum. 
 
Put another way, an investment of £100,000 in May 2000 grew to £1,639,620 today with our Dynamic Portfolio, or £188,390 with an index tracker – an extra £1,451,230, by making more intelligent fund choices by learning from research which stretches over a century. Remember, these numbers are after fund charges.
 
That is what Elroy calls a “premier anomaly”. It is what I call a massive improvement for retail investors who have been poorly served for decades.
 
FURTHER READING
 
Bibliography On Momentum from AQR:
 
“Here is a selected list of books, journal articles and working papers that we found helpful in developing our research around Momentum strategies.
 
Asness, Cliff, 1994, “Variables That Explain Stock Returns,” dissertation, University of Chicago
 
Asness, Cliff, 1997, “The Interaction Between Value and Momentum Strategies,” Financial Analysts Journal 53(2), 29–36
 
Asness, Cliff, Burt Porter and Ross L. Stevens, 2000, “Predicting Stock Returns Using Industry-Relative Firm Characteristics,” working paper, AQR Capital Management
 
Asness, Cliff, John M. Liew and Ross L. Stevens, 1997, “Parallels Between the Cross-Sectional Predictability of Stock and Country Returns,” The Journal of Portfolio Management 23(3), 79–87
 
Asness, Cliff, Tobias J. Moskowitz and Lasse H. Pedersen, 2013, “Value and Momentum Everywhere,” The Journal of Finance, 68(3), 929–985
 
Barberis, Nicholas, Andrei Shleifer and Robert Vishny, 1998, “A Model of Investor Sentiment,” Journal of Financial Economics 49(3), 307–343
 
Carhart, Mark M., 1997, “On Persistence in Mutual Fund Performance,” The Journal of Finance 53(1), 57–82
 
Chan, Louis K.C., Narasimhan Jegadeesh and Josef Lakonishok, 1996, “Momentum Strategies,” The Journal of Finance 51(5), 1681–1713
 
Daniel, Kent, David Hirshleifer and Avanidhar Subrahmanyam, 1998, “Investor Psychology and Security Market Under- and Overreactions,” The Journal of Finance 53(6), 1839–1886
 
Fama, Eugene F., and Kenneth R. French, 1996, “Multifactor Explanations of Asset Pricing Anomalies,” The Journal of Finance 51(1), 55–84
 
Fama, Eugene F., and Kenneth R. French, 2008, “Dissecting Anomalies,” The Journal of Finance 63(4), 1653–1678
 
Frazzini, Andrea, 2006, “The Disposition Effect and Underreaction to News,” The Journal of Finance, 61(4), 2017–2046
 
Griffin, John M., Xiuquing Ji and J. Spencer Martin, 2005, “Global Momentum Strategies: A Portfolio Perspective,” The Journal of Portfolio Management, 31(2), 23–39
 
Grinblatt, Mark, and Bing Han, 2005, “Prospect Theory, Mental Accounting and Momentum,” Journal of Financial Economics, 78(2), 311–339
 
Grinblatt, Mark, and Tobias J. Moskowitz, 2004, “Predicting Stock Price Movements from Past Returns: The Role of Consistency and Tax-Loss Selling,” Journal of Financial Economics, 71(3), 541–579
 
Grundy, B.D., and J.S. Martin, 2001, “Understanding the Nature of the Risks and the Source of the Rewards to Momentum Investing,” The Review of Financial Studies 14(1), 29–78
 
Hong, Harrison, and Jeremy C. Stein, 1999, “A Unified Theory of Underreaction, Momentum Trading and Overreaction in Asset Markets,” The Journal of Finance, 54(6), 2143–2184
 
Hong, Harrison, Terence Lim, Jeremy C. Stein, 1999, “Bad News Travels Slowly: Size, Analyst Coverage, and the Profitability of Momentum Strategies,” The Journal of Finance, 55(1), 265–296
 
Hvidkjaer, Soeren, 2006, “A Trade-Based Analysis of Momentum,” The Review of Financial Studies 19(2), 457–491
 
Jegadeesh, Narasimhan, and Sheridan Titman, 1993, “Returns to Buying Winners and Selling Losers: Implications for Stock Market Efficiency,” The Journal of Finance 48(1), 65–91
 
Jegadeesh, Narasimhan, and Sheridan Titman, 2001, “Profitability of Momentum Strategies: An Evaluation of Alternative Explanations,” The Journal of Finance, 56(2), 699–720
 
Lee, Charles M.C., Bhaskaran Swaminathan, 2000, “Price Momentum and Trading Volume,” The Journal of Finance, 55(5), 2017–2070
 
Moskowitz, Tobias J., Mark Grinblatt, 1999, “Do Industries Explain Momentum?” The Journal of Finance 54(4), 1249–1290
 
Rouwenhorst, K. Geert, 1998, “International Momentum Strategies,” The Journal of Finance 53(1), 267–284
 
Rouwenhorst, K. Geert, 1999, “Local Return Factors and Turnover in Emerging Stock Markets,” The Journal of Finance, 54(4), 1439–1464
Topic: Fund analysis


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