The skinny on momentum investing strategies

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What’s the No. 1 investing sin of small investors?

Chasing performance.

A “trendy” investing strategy does just that, but the difference is that it’s done systematically and with a plan. A momentum strategy basically follows trends — but it’s not only about buying the hottest stocks or assets. The strategy can be used as an attempt to reduce risk as well as outperform.

“Essentially, it’s a strategy that uses the past performance to determine what stocks to buy and what stocks to sell,” says Ryan Larson, CFA, vice president of institutional relations at Research Affiliates, an indexing and asset allocation consultant.

The basic strategy

There’s a plethora of academic research on momentum investing strategies. Larson himself authored a research paper, “Hot Potato: Momentum as an Investment Strategy.”

Essentially, momentum indicates that the price of an asset or assets moving up or down will continue in that direction — until it stops.

There are two broad ways to look at momentum. One compares asset classes to others, or one stock to another stock, and is called cross-sectional momentum.

Investors interested in constructing a portfolio based on cross-sectional momentum investing would compare the returns on a group of stocks over a specified time period and use the data to determine how to invest.

David Ott, partner at Acropolis Investment Management in St. Louis, explains one way to do this: “Rank all of the stocks in a particular index like the Russell 1000 by their most recent 12-month performance, excluding the most recent month. Go long the top third and if possible, short the bottom third.”

Taking a long position involves buying stocks outright in the expectation that they will appreciate in value. When shorting stocks, investors bet against them and profit when their prices decline.

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Although the most recent 12 months’ performance minus the most recent month is a popular metric, academics are not entirely in agreement on what constitutes the best “recent” time frame.

“‘Recently’ can mean anything from a month or two or a quarter, but no longer than a year,” says Jacob Sagi, associate professor of finance at the University of North Carolina at Chapel Hill. “Also, ‘recently,’ when dealing with momentum strategies, is definitely not days.”

Besides ranking stocks, investors should look for particular characteristics in companies that perform well in a momentum strategy, according to Sagi.

“Momentum, when used as a stock investment strategy, appears to be more prevalent or profitable when it’s restricted to smaller firms, growth firms, firms with lower operating leverage, firms with higher sales volatility, firms with lower credit quality,” he says.

After a specified period of holding time, the investor would re-rank the stocks and sell the positions that had fallen from the top spots.

“The holding period that historically seems to have been profitable would be anywhere from a quarter to a few months, but generally less than year,” says Sagi.

Reducing risk

In comparison to cross-sectional momentum, a “time series” approach examines how a security or asset, or even an asset class, is performing compared with its past performance. One example of its use is in risk reduction.

Momentum doesn’t apply just to individual stocks compared with other stocks; investors can compare the movement of asset classes against other asset classes.

“If you look at an asset class, or even a stock, using a long-term trend metric can work great. A simple example is something like 200-day simple moving average to eliminate the noise and find out what’s going on with that asset class,” says Mebane Faber, a portfolio manager at Cambria Investment Management and author of “Shareholder Yield: A Better Approach to Dividend Investing.” Faber also wrote an influential paper on market timing called, “A Quantitative Approach to Tactical Asset Allocation.”

The 200-day moving average involves averaging the closing prices of a stock over the past 200 trading days. If the price dips below its 200-day moving average, usually by a pre-specified degree or percentage, then investors can take that as a signal to sell.

“Using something like that as a signal to get out — typically what that does, it will reduce the volatility and maximum loss that an investor will experience in any one asset class,” Faber says.

Drawbacks of momentum for small investors

Although studies have shown that momentum investing strategies have proved profitable, at least theoretically, there are some drawbacks for small investors.

To short stocks, investors need a margin account that will let them borrow against the value of their securities. They borrow shares of the stock they want to short from their broker and sell them at the market price. After the price goes down they buy the shares at the new, lower price and return them to the broker, pocketing the difference.

An investor following a momentum strategy would short a group of stocks that have performed poorly over a recent time period; that’s where most of the profitability of the strategy has been found historically, according to Sagi.

Unfortunately, shorting a basket of stocks could be prohibitively expensive for many investors. Shorting requires a high tolerance for risk because the potential for loss could be great.

Trading costs are also a drawback. “Momentum strategy requires you to churn stocks quite actively,” says Sagi.

Any returns above those the broad market serves up can be eaten away by trading commissions. And investors can’t forget about taxes. A successful short-term trading strategy can lead to short-term capital gains taxes, so experts recommend using a tax-deferred account to trade in.

Another drawback for investors is the time commitment. A momentum strategy isn’t something to put on autopilot.

“Stocks have to constantly be monitored on a daily, or even hourly, basis. Most investors that are not investment professionals don’t have the time or expertise to follow stocks that frequently,” says Tom Kerr, CFA, portfolio manager of the Rocky Peak Small Cap Value Fund.

Because of the risks and attendant costs, both Sagi and Larson recommend against using a momentum strategy as the only approach in a portfolio.

“Use momentum as a way to complement or trade around a strategy that you believe, such as value or rebalancing,” says Larson.

Although momentum investing strategies can be profitable, they might not be the best answer for most long-term investors.