A Simple Explanation Of Momentum

April 26, 2016

This article is part of a regular series of thought leadership pieces from some of the more influential ETF strategists in the money management industry. Today's article is by Ben Lavine, chief investment officer of 3D Asset Management based in East Hartford, Connecticut.

A few years ago, I attended an iShares gathering right when “strategic beta” (no, I don’t call it “smart beta”) emerged as an increasing focal point for ETF product innovation.

The speaker walked through the series of single-factor ETFs based on MSCI Factor Indices and why several institutions, such as the Arizona State Retirement System, were adopting strategic-beta strategies.

Why The Momentum Anomaly Persists

When the topic came to momentum, the speaker immediately confessed a certain level of confusion on why the momentum anomaly exists when, from an efficient market hypothesis (“EMH”) standpoint, prices should follow a random walk rather than a trend line—or just because the price of an asset was higher yesterday doesn’t mean it should be higher tomorrow.

Momentum has become a recent hot topic, because it was one of few strategies to have performed well in a difficult 2015 market environment.

Momentum King Of 2015

Yet momentum is struggling this year as the snapback rally off the February lows has left last year’s winners lagging last year’s losers.

Revenge Of The Contrarian

On the surface, momentum is anti-intuitive for many investors, whether those who subscribe to EMH, those who are contrarian or those who just like rooting for the underdog.

At various points in my career, I subscribed to all three viewpoints and had looked with disdain on investors who pushed growth momentum strategies. But at the core of my disdain was a lack of understanding and appreciation for why the momentum anomaly persists, whether in stocks, commodities or currencies.

What Is Momentum?

Despite being anchored to a contrarian view, there was this nagging observation that 52-week highs more often made new highs, while 52-week lows made new lows. In a majority of cases, it doesn’t pay to be a contrarian, and you’re better off betting on a basket of winners rather than losers. So what is momentum exactly?

Technically speaking, momentum represents an accelerated (second-derivative) move off a positive or negative trend (first-derivative), but many investors associate momentum with both.

Simple momentum investing involves two things:

  • calculating an asset class’ return over a short-term (three- or six-month) or intermediate-term (12- or 18-month) time frame
  • taking the difference between the outperforming versus underperforming securities or subasset classes

Many technicians or chartists favor positively trending asset prices and monitor moving averages such as the 90- or 200-day moving average. The key is to look for “breaks” in trend or momentum, such as the breach of moving average levels, or the crossover of the short-term over the long-term moving average (so-called death cross), or the breach of other support/resistance levels (e.g., head-and-shoulders).

I had been a skeptic of technical analysis, but an ex-colleague reminded me that it doesn’t matter whether I believe in technical analysis; what matters is that enough market participants believe in technical analysis to the extent that this worldview of investing can affect market pricing. This is most evident in currency markets due to the presence of dynamic hedgers who constantly adjust positions based on price trends.

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