Momentum investing: what it is, why it works and what to buy

Momentum investing – buying what has already gone up in price in the belief that it will keep doing so – shouldn’t work in theory. Yet in real life, it does. Stephen Connolly looks at why – and what to buy.

As an investment strategy, momentum investing sounds too good to be true. You simply buy the shares that have risen most strongly. Take an index say the FTSE UK All Share or MSCI USA and rank its members by performance over the previous 12 months. Then buy the top 20% or so. Repeat every three to six months, each time resetting the portfolio with the latest top gainers. It's entirely mechanical. There's no poring over company reports, or trying to gather unique insights. And yet it works: to 25 May this year, the iShares USA Momentum tracker has delivered 8.1%, compared with the MSCI USA index's 2.5% total return. Meanwhile, the average active US large-cap fund manager made just 1.8% over the same period (according to data provider Morningstar).

Momentum investing emerged officially as an investment style 20-25 years ago (although it has existed for much longer). Academic research validates the approach last year well-known investment academics Elroy Dimson at the Cambridge Judge Business School and Paul Marsh of London Business School noted that between 1900 and 2016 UK stocks that had beaten the market in the previous 12 months returned 14.1% on average over the subsequent 12 months. Shares that had underperformed averaged only 3.6% the next year. In the US, the winners turned in 17.5% versus 9.5% from the laggards (between 1926 and 2016).

An inconvenient truth

What's irritating for the academics is that momentum investing shakes a core, albeit controversial, building-block of financial theory that markets are efficient. In theory, a properly functioning market immediately incorporates all known information about a company. Therefore, share prices are always fairly valued. Momentum is problematic because it signals that in the real world investors react to prices emotionally. When a share price rises, a fear of missing out can attract an accelerating stream of buyers, while a falling price can prompt selling because investors worry that the market knows something they don't. All of this can take place in the absence of new information on a company and is thus theoretically irrational, exposing markets as inefficient. As Professor Marsh, referring to a 2007 paper that also highlighted momentum's positive returns, put it: "We remain puzzled [in explaining the data] and we are not the only ones; most academics are vaguely embarrassed by this."

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It's easier to explain momentum investing if you think about how people (including, perhaps, yourself) tend to invest. Companies report good news and growing profits, encouraging analysts to raise their earnings and price targets and write "buy" notes to clients. A "bandwagon" effect develops as more and more investors buy in. Some get in at the start, while others arrive over time, as the rising share price helps to endorse their favourable view of the stock. In turn, that attracts wider and more positive press coverage, and ever-bolder forecasts. This is what we all want as investors indeed, whether we use the term or not, we all want to hunt down investments that will gather enough momentum to outperform.

A profitable anomaly

In any case, however we might explain such behaviour, the fact is that it happens. Momentum is an anomaly, which in turn is an opportunity, and a highly exploitable and consistently profitable one at that. So it's hardly surprising that numerous funds have embraced it. We've already touched on the USA Momentum exchange-traded fund (ETF) more formally the iShares Edge MSCI USA Momentum Factor ETF (NYSE: MTUM) and its strong returns this year. It's now nearly five years old, with $8bn of assets under management. It returned 14.5% (versus 12.7% for the MSCI USA index) in 2014, 9.1% (0.7%) in 2015, 4.9% (10.9% the benchmark won that year) in 2016 and 37.6% (21.2%) in 2017. In all, that's 66.1% from the ETF (after an annual fee of just 0.15%), well ahead of the market's 45.5% total return. It might be tempting to put the superior performance down to the current strength of tech, a sector that features heavily (at 36%). But it's not the only show in town financials, consumer discretionary, industrial and healthcare stocks have delivered good returns too. Top 20 holdings include Microsoft, JP Morgan, Boeing, Visa, Home Depot, Accenture and Nike.

As John Authers notes in the Financial Times, momentum is vulnerable to significant market falls, when the strategy can suddenly take second place to heavily bombed-out value stocks as investors reposition for a rebound. But that's no different from any other strategy. He also notes that momentum isn't especially volatile, and that before a tough period in 2009 (mid-financial crisis), you'd have to go back to 1932 to find similar levels of volatility.

How to follow momentum investing strategies

In any event, diversity is healthy for a portfolio. Adding an element of momentum to your investments should boost long-term returns. But it can also balance outperformance for example, momentum often does well when value is struggling. On the other hand, when value is very strong, it will most likely beat momentum for some of that time. But don't rush off to identify the best-performing stocks over the past 12 months a home-made momentum strategy would likely prove a burden for an individual investor: monitoring the performance of all the constituents in a large index is a hassle. Instead, you should outsource the "heavy lifting" to a momentum ETF.

The most established provider in this area is iShares, part of BlackRock. It offers various versions of these ETFs in different currencies we've opted for the sterling versions. The London-listed version of the aforementioned iShares USA Momentum trades under the ticker IUMF. The annual fee is a bit higher but still very competitive at 0.2%. There's also a global version, iShares Edge MSCI World Momentum Factor ETF (LSE: IWFM), although the US features heavily (annual charge: 0.3%). Finally, there's the iShares Edge MSCI Europe Momentum Factor ETF (LSE: IEFM), which invests in 15 European countries including the UK and Switzerland (annual charge: 0.25%).

Investment columnist

Stephen Connolly is the managing director of consultancy Plain Money. He has worked in investment banking and asset management for over 30 years and writes on business and finance topics.