Be Wary of Momentum Investing Strategies
In basic physics, the principle of momentum is intuitive: Give a billiard ball a tap, and the ball will keep rolling in the same direction from one second to the next.
It’s tempting to apply the same logic to stocks. After all, study after study has found that, historically, stocks with prices that rose or fell over a few hours or months were disproportionately likely to keep heading in the same direction for at least the next few minutes (if the trend was marked over hours) or weeks (if the trend was established over recent months).
And momentum investing has been on a roll of late. If, after watching the S&P 500 index rise more than 26% in 2023 (largely driven by a handful of tech stocks), you had decided “the trend is your friend” and bought a fund that tracks the large-company benchmark at the start of 2024, you’d have made more than 15% in the first half of the year.
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Funds that use momentum as a primary factor in their screening process, buying or selling stocks on the assumption that their past price trends will continue, have been the best-performing factor funds (funds that focus on a particular investing characteristic) so far in 2024, according to research firm Morningstar.
Invesco S&P 500 Momentum, an exchange-traded fund that tracks an index of S&P 500 companies that score high on certain momentum measures, has returned a market-beating 34% so far this year and 61% over the past 12 months, putting it in the top 1% of all large growth funds for both periods. (Data are as of June 30.)
But don’t get too excited, warns Morningstar portfolio strategist Amy Arnott. Momentum is actually one of the more puzzling and risky investing strategies in common use. “The tricky thing with momentum is that it works until it doesn’t. During turning points, momentum funds really struggle,” she says.
Consider the recent stumbles of the above-mentioned Invesco fund. The ETF updates its portfolio only every six months, and that lag is one reason the fund ranked in the bottom 10% of its category in 2019 and 2023, two years when the market experienced turnarounds. Because of the 2022 bear market, for example, Nvidia dropped out of the index the momentum fund tracks, so the fund missed out on the chip designer’s gains for much of 2023, Arnott says. (Nvidia is now the fund’s top holding, and tech is its top sector, accounting for more than half of assets.)
In other words, momentum investing requires that investors be both watchful and nimble. Before you start chasing stock price trends, take a moment to explore what momentum is, why it works, and the most practical ways individual investors can use momentum.
Millions of momenta: What investors need to know
Although it’s clear that momentum is about cashing in on persistent trends, there’s no general agreement on which trends, or over what time period. Nearly every momentum investor or fund manager has a unique formula. Some track individual stocks. Others track sectors or baskets of funds. Some strategies, such as those tracking the S&P 500 and MSCI momentum indexes, focus on price history.
Another popular momentum strategy — used, for example, by funds tracking indexes created by the research firm Nasdaq Dorsey Wright — pays little attention to the historical direction of prices, focusing instead on relative performance and screening for outperforming and underperforming stocks or other investments. There are also many options for the time period used to flag a trend. Some investors bet on trends of the past few hours; others look over many months or years, sometimes ignoring the most recent days or even months.
Those differences in trend-spotting strategies create huge variations in performance. Over the past 12 months, the returns of funds that relied heavily on momentum ranged from 60.6% for the Invesco S&P 500 Momentum fund to 6.5% for Invesco Dorsey Wright Basic Materials Momentum, an ETF focused on materials firms outperforming their peers.
You might expect stocks with strong fundamentals to enjoy upward momentum as long as that favorable foundation persists. But there’s also an element of investor psychology to momentum investing, says Jonathan Treussard, who runs Treussard Capital Management.
History is full of examples of upward momentum being accelerated by investors’ lemming-like fear of missing out on a hot stock. Falling prices can likewise be reinforced by trend-chasers, as well as by market mechanics such as margin calls, says Treussard. (A margin call is when a brokerage calls upon an investor who borrowed money to buy a stock to either pony up more cash or sell the stock if the price falls below the brokerage’s margin of safety for that stock.)
Tread carefully with your strategies
Long-term-oriented, do-it-yourself investors should approach momentum investing with caution. Think of momentum as a satellite strategy for your portfolio, not as a core position. Because momentum funds tend to zig when value-oriented funds zag, adding a smidgen of momentum funds to your portfolio improves your diversification, says Nick Kalivas, head of factor and core equity strategy for Invesco, which offers 21 momentum-based ETFs.
Look for ways to limit your risk. One of the most potentially profitable momentum strategies is also among the riskiest, says Larry Swedroe, author of several investing books including this year’s Enrich Your Future: The Keys to Successful Investing. The tactic doubles down on momentum by betting on some stocks to rise while simultaneously selling others short because you think they’ll keep falling.
To reduce your risk — but also potential rewards — you can opt for funds that only invest in rising stocks. Those who want even less volatility can consider strategies that add considerations of earnings quality and value to momentum characteristics.
The managers at Hennessy Cornerstone Growth fund, for example, screen for companies with rising stock prices over the past three and six months, but they also insist on rising earnings and a stock price that equates to no more than 1.5 times the company’s sales per share. The fund’s returns typically don’t hit the highs of many pure momentum funds. But the Hennessy fund has been less volatile than momentum funds in general, and its five-year annualized return of 17.5% puts it in the top percentile of its category (small companies with a blend of growth and value characteristics). Over the past three years, Hennessy’s biggest drop was 17.2%, compared with 25.7% for momentum funds overall.
If you decide to pursue momentum investing, make sure to be smart about taxes. Momentum strategies typically require plenty of trading, which could create taxable gains, notes Swedroe. For that reason, holding a momentum strategy ETF (or a mutual fund in a tax-protected account) may be a more tax-efficient way to pursue the strategy, he says.
Note: This item first appeared in Kiplinger Personal Finance Magazine, a monthly, trustworthy source of advice and guidance. Subscribe to help you make more money and keep more of the money you make here.
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