The phenomenon behind momentum is probably best explained by behavioural finance theories. Momentum exists because of investors’ behavioural biases—the action of individual investors tends to exacerbate market trends, and some investors only gradually adjust their beliefs to new information.
Momentum investing seeks to increase exposure to companies that are outperforming over the last 12 months, while decreasing exposure to underperformers.
Academic research suggests that momentum investing is commonly identified as leading to outperformances of traditional indices when implemented, Adam Bajcarz, head of portfolio management of Apt Wealth says.
In its simplest form, an investor buys stocks who’s share price has been rising, and is expected to continue to rise, while selling stocks that have been falling in price and as a result, are expected to continue to fall, Bajcarz explains.
“A traditional market-capitalisation weighted equity index is a form of momentum investing; as a stock price rises the weight in the index increases,” Bajcarz says.
“Similarly, when the momentum turns negative, the stock price falls, the weight in the index decreases.”
“It’s useful to differentiate between long term trends that might be supported by a long-term industry trend which is increasingly the profitability of the company’s stock versus a short-term trend that is based mainly on market sentiment.”
A trending stock might capture the market’s attention, meaning that in the short term, the stock price may well run ahead of the underlying fundamental value.
“If you’re an early investor, this can lead to outsized gains in the short term,” he says. “The difficulty is in determining when that trend will end.”
But it’s far from foolproof. If a trending stock has long term fundamentals supporting the share price rise it can lead to significant outperformance of traditional indices. Investors also need to remember to avoid short term or cyclical impacts such as the impact of lockdowns during the Covid-19 pandemic.
When it comes to taking an index approach using ETFs, Salt Financial Group financial adviser Ben Waite outlines six steps to integrate factor ETFs into client portfolios.
The first step begins with a client assessment to identify financial goals, risk tolerance, and investment horizon.
The second step is portfolio strategy and, in this context, deciding if factor ETFs are either core or satellite positions.
The third and fourth steps are factor selections – selecting the relevant factors based on the client assessment – and evaluating the expense ratios, tracking error, liquidity, holdings and issuer’s reputation of the ETF.
Then the final two steps are portfolio construction – determining the weighting of each ETF and establishing a rebalancing strategy and managing risk – along with regulatory reviewing performance and market conditions and making any portfolio adjustments based on the client’s situation.
With this in mind, momentum factor ETFs would be used in the third step of the firm’s ETF integration.
“We tend to look at historical performance for each factor and how they correlate with other factors and other traditional asset classes,” Waite says.
“The momentum phenomenon suggests that investor biases and gradual belief adjustments to new information drive market trends.”
