Momentum Investing 101

In its most basic form, momentum investing is the idea of profiting from the continuation of existing price trends in the market. You’ve probably heard the phrase – the trend is your friend – which succinctly encapsulates the root of momentum investing: a price trend is more likely to continue in the established direction than it is to reverse course.

In portfolio management terms, momentum investing boils down to the following:

• For long positions, buy the securities that have been outperforming the broader market (or some other competitive set) in the past few months.

• For short positions, sell the securities that have been underperforming the broader market in the past few months

In other words, you want to “place your bet” in the direction that the given security has moved in the preceding trading sessions. Hence, going with momentum.

Momentum investing seems supportive of the “herd mentality” we’ve all been taught to avoid. This is why many investors are hesitant to embrace this type of approach. We’ve all been beaten over the head with the phrase “past performance is not a guarantee of future returns”, and so it’s only natural that momentum investing appears a bit irrational at first glance.

Perhaps the two most often cited reasons for why an investor is likely to avoid a momentum-based security selection approach are that

1. Stocks that have been going up for a while (or down) are “overvalued” (or “undervalued), and

2. Stocks that have been going up for a while (or down) are more susceptible to reversals.

All in all, momentum investing is all too often perceived as being “too risky” for consideration.

As you might suspect, what is perceived one way in theory is often not so in reality. Momentum investing is no different. Plain and simple, there is a plethora of academic evidence supporting the merit of momentum investing. For starters, consider the French Data Library which has historical data on different factor-based investment strategies.

Dorsey Wright compiled the following research which compares the three hypothetical momentum portfolios; all are equally weighted and rebalanced monthly, with the “high” option consisting of the stocks that had the strongest momentums over previous 12-month period, “middle” representing moderate momentum stocks, and “low” representing the securities with the weakest momentum.

Based on nearly nine decades of data, the “high” momentum portfolio produced annualized returns of 15.08%, trumping the “middle” (10.46%) and “low” (4.56%) portfolios by a wide margin. Simply put, “buying the winners” has worked remarkably well over time.

Read more about Why Momentum Investing Works.

In their most basic form, momentum-based ETFs are not at all complicated instruments. You start with a broad-based index, like the S&P 500 Index for example, and refine it down so you’re left with the securities exhibiting the strongest momentum characteristics. This could be as simple as the following steps:

• Compile a list of the trailing one-year returns for each of the 500 stocks.

• Rank the stocks in order of strongest to weakest based on trailing returns.

• Isolate the top 100 securities and create an equal-weighted portfolio.

Your resulting portfolio would in turn resemble something like that “high” momentum example from above; it’s identical in that you are concentrating your exposure entirely on the strongest momentum stocks, giving no attention to those that simply fail to make the cut.

There more than half a dozen ways to access a momentum-based strategy via the ETF wrapper. See all Momentum ETFs here.

The most popular and established fund by far is the Dorsey Wright Focus 5 ETF (FV B) which boasts well over $4 billion in AUM.

Don’t be quick to pass on a momentum-based strategy because you feel it’s probably too risky. Take the time to read about it and historical studies that support this investment approach so you may uncover its nuances and drawback and ultimately determine if it is appropriate for you.

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