Exploring momentum investing

Momentum investing is a valuable tool for building diversified portfolios with above-average returns. Although the momentum style of investing has been known to financial academics for many years, for most investors in Nigeria, this remains an “undiscovered territory”.

Momentum is the tendency of investments, in every market and asset class, to exhibit persistence in their relative performance for some period of time. When applied to stock picking, momentum (like value or growth) is about relative performance among stocks, and not about overall trends in the market. It works whether a market is in an upswing or downswing. Momentum can be used to identify securities likely to outperform, making it a powerful investment tool. It is also negatively correlated to value investing, making it an effective diversification component.

The evidence for momentum is pervasive, supported by almost two decades of academic research. Recent studies show evidence for momentum in a range of global asset classes and markets. Since these are long-short returns, they are independent of gains from market exposure. Their results also suggest momentum delivers attractive Sharpe ratios (risk-adjusted returns) universally.

Many possible explanations of momentum have been adduced. One is that momentum’s higher returns are compensation for some unique risk associated with investments that have recently outperformed. As of yet, no such risk factor has been convincingly identified. If it is not compensation for risk, the existence of momentum challenges the efficient market hypothesis that past price behaviour provides no information about future behaviour.

Several possible behavioural explanations have also been put forth. The first is that investors may be slow to react to new information. Efficient market theory assumes that once new information is released, it is instantly available to all investors and that prices immediately adjust to reflect the news. In practice, however, different investors (for example, a trader versus a casual investor) receive news from different sources, and react to news over different time horizons and in different ways. Also, anchoring and adjustment is a behavioural phenomenon in which individuals update their views only partially when faced with new information, slowly accepting its full impact. There is ample evidence supporting slow-reaction-to-information theories, ranging from market response to earnings and dividend announcements to analysts’ reluctance to update their forecasts.

Investors are also prone to what behavioural economists and experimental psychologists call the disposition effect. Investors tend to sell winning investments prematurely to lock in gains, and hold on to losing investments too long in the hope of breaking even. The disposition effect creates an artificial headwind: when good news is announced, the price of an asset does not immediately rise to its value because of premature selling. Similarly, when bad news is announced, the price falls less because investors are reluctant to sell.

There is evidence that investors are susceptible to the bandwagon effect (also called over-reaction). Short-term traders may use recent performance as a signal to buy or sell. Longer-term investors look to recent performance to confirm their convictions. The interaction between these investors can create price run-ups or -downs that can persist for many months until an eventual correction. What is clear is that the overwhelming evidence from a range of markets, asset classes, and time periods supports the argument that momentum is neither a random occurrence nor an effect that disappears once the impact of transaction costs is incorporated.

It was on the back of this overwhelming evidence that we decided to explore the existence of the momentum premium in the Nigerian equity market. Most of the global methodologies are designed around annual series, but due to the lack of depth in the Nigerian market and its peculiar characteristics, we designed our strategy around quarterly data series, using only the positive momentum scores. Our data series covers 2006 to 2014. We determine momentum by looking at the excess return of every stock over the risk-free rate in each universe over the past six months and most recent three months. The maximum score for each stock is ‘winsorized’ to 3, and the maximum weight for each sector limited to 25 percent to avoid concentration risk.

The momentum score at time t is applied to weight the basket for time t+1. Our results suggest that the momentum strategy is a far superior investment style over the commonly-used market capitalization. Between 2006 and 2014, our momentum indices returned an average of 62.99 percent and 65.76 percent annually. These dwarf the 11.98 percent average annual returns of the NSE-ASI. Asides the superior return, another positive of the momentum strategy is that it is a good forecasting tool for impending market downswings. The number of stocks with positive momentum scores during these periods is usually below 10 (the minimum needed for our portfolio). This helps in managing risk.

Momentum is much more than buying a handful of hot stocks – it is a disciplined, systematic investing style that applies across asset classes. Momentum is a phenomenon driven by investor behaviour: slow reaction to new information; asymmetric responses to winning and losing investments; and the “bandwagon” effect. Numerous academic and practitioner studies have confirmed momentum’s existence.

Virtually all investors can expect higher risk-adjusted returns by adding momentum to their portfolios. Growth investors will see that momentum delivers much better performance. Value investors will find momentum to be an effective complement. Value-growth investors will want to consider momentum as an alternative to their growth allocation.

For all our love for fundamental investing, evidence abounds about the influence of human behaviour on investment decisions. These present opportunities that can be systematically harnessed.

 

Olugbenga A. Olufeagba