Momentum investing has established itself as a fundamental element of systematic equity strategies, capturing the attention of investors seeking to optimize their portfolios. Recent investigations shed light on the empirical evidence and practical developments surrounding this investment approach, emphasizing its significance for long-term allocators.
Through an extensive analysis that encompasses over 150 years of data and numerous portfolio configurations, we reaffirm the durability of momentum investing while recognizing its evolution into a more complex strategy.
The momentum premium is not just a statistical anomaly but a robust phenomenon that has consistently generated substantial returns across different market conditions and geographical regions.
Table of Contents:
The enduring nature of momentum investing
The primary characteristic that sets momentum investing apart is its long-standing persistence. This is illustrated by a straightforward long-short strategy that involves purchasing past winners and selling past losers. Over a span of 150 years, this strategy transformed an initial investment of $1 into a staggering $10,000, showcasing annualized returns in the range of 8% to 9%. Such returns are not only impressive but also statistically significant, with t-statistics exceeding commonly accepted thresholds for determining genuine results.
This remarkable performance remains unaffected by variations in portfolio construction techniques. Whether the portfolios are value-weighted or equal-weighted, and regardless of how momentum is defined or the time period analyzed, the premium consistently holds. This resilience across various methodologies strengthens the assertion that momentum reflects a fundamental feature of financial markets rather than a temporary occurrence.
Implications for institutional investors
For institutional investors, the message is clear: momentum persists across different eras and market environments, suggesting that it is a structural characteristic of financial markets. However, it is crucial to recognize that momentum should not be viewed as a one-size-fits-all strategy. The performance of momentum investing is heavily influenced by the construction of the portfolio.
Factors influencing momentum strategy performance
Design decisions, such as whether to use value-weighted versus equal-weighted returns, where to set breakpoints, and the inclusion of microcap stocks, significantly impact both the level of returns and associated risks. To assess this sensitivity, we analyzed over 4,000 variations of momentum portfolios, all of which yielded positive Sharpe ratios, indicating the robustness of the momentum premium. Yet, the performance results varied widely, with the median Sharpe ratio at 0.61, while individual strategies ranged from 0.38 to 0.94.
This variation highlights the necessity for thorough specification checks and transparency in factor design, especially crucial for benchmarking and reporting purposes. As research in momentum investing has evolved, it now encompasses a broader range of trends beyond simple price movements. New approaches, including fundamental momentum based on earnings surprises and news sentiment, reflect investors’ tendencies to underreact to new information.
Alternative momentum strategies
Additionally, concepts like residual momentum focus on firm-specific return patterns, isolating company-level news and typically yielding smoother results with higher Sharpe ratios. Other forms of momentum, such as industry momentum, capture both top-down macroeconomic trends and bottom-up relationships between products and markets. These diverse signals are not only imperfectly correlated with traditional price momentum but also with one another, providing valuable diversification opportunities.
A composite approach that equally weights price momentum alongside ten alternative signals has shown enhanced average returns and improved risk characteristics compared to relying solely on price momentum. This multidimensional composite demonstrates the merits of diversifying momentum signals to achieve superior risk-adjusted returns.
Managing risks in momentum investing
Despite its strengths, momentum investing is not without its pitfalls. The most notable risk is the potential for sharp reversals, especially during significant market shifts. Our research indicates that traditional price momentum strategies can experience maximum drawdowns as severe as -88%, accompanied by left-skewed and fat-tailed return distributions.
Nevertheless, many alternative momentum signals exhibit reduced volatility, and the multidimensional composite effectively mitigates risks associated with traditional price momentum. By employing volatility scaling strategies at both the stock and portfolio levels, we can significantly lessen drawdowns while enhancing Sharpe ratios. The resulting risk-managed momentum strategy has achieved annualized returns approaching 18% with volatility comparable to standard momentum, while nearly halving drawdowns.
For institutional investors, these findings underscore the importance of factor construction and the need for rigorous checks across portfolio designs. By diversifying momentum signals and adopting risk management techniques, investors can capture persistent alpha while navigating the inherent risks of the market.
