Momentum investing has something of an image problem. It is not particularly sophisticated to say that we are buying a security because its price is going up or selling it because it is going down. It appears far superior to make investment decisions based on the elaborate fundamental analysis of a company or forensic due diligence of an actively managed fund. Despite a somewhat unattractive reputation, however, most of us are momentum investors. We just don’t want to admit it.
What are the attractions of momentum investing?
In its most simple terms momentum investing is buying assets that are performing well, whilst abandoning the laggards. There are a range of reasons why investors find this secretly appealing:
1) It’s easy: Doing momentum investing badly is incredibly easy. It takes barely any effort to know which asset classes and securities are in-vogue. (Conversely, good momentum investing is difficult, particularly behaviourally).
2) It’s comfortable: Investing in things that are working right now and selling those that aren’t is incredibly comforting. It makes us feel good and worry less.
3) We extrapolate: We cannot help but think that what has happened recently will persist into the future.
4) We build stories around performance: When an asset is performing well, we create stories to justify it. Positive performance momentum leads us to form a compelling and persuasive investment narrative. A virtuous / vicious circle which increases our conviction.
5) We are comfortable in the crowd: Chasing momentum means following the crowd. Not only do we think that crowd behaviour provides us with information; taking a contrarian stance against it carries a host of unpleasant risks.
6) Our career might depend on it: Momentum investing can be a useful survival strategy in the asset management industry, even if it destroys value over the long-term. Always telling clients how we are invested in the latest flavour of the month areas might just keep us from getting fired.
Why don’t we admit to being momentum investors?
Despite the appeal of momentum investing, few of us admit to being profoundly influenced by it (excluding those who are running explicit momentum strategies). It is just too simple.
Although the majority of active fund investors chase performance, they rarely acknowledge it as the major influence on their decision making. Even when using a dreaded performance screen to filter a universe of funds (which ingrains momentum into the selection) this will be framed as a minor part of the process, before the more detailed research begins.
It is just not feasible to say to colleagues or clients: “we invested in this fund primarily because it was performing well”, even if this is the case. (We will also inevitably persuade ourselves that positive performance momentum wasn’t the significant driver of our decision).
Why doesn’t being an implicit momentum investor work?
There is a major problem with momentum being our implicit investment strategy – it doesn’t work. We are likely to be wildly inconsistent in our behaviour. Erratic, driven by noise, emotion and perverse incentives. We will be frequently whipsawed and often under-diversified.
Each time we make investment decisions that are implicitly driven by momentum it makes us feel better for a time; but what will feel like short-term wins, almost inevitably compound into painful, long-term losses.
But momentum investing does work!
Why am I claiming that momentum investing doesn’t work, when it is one of the most empirically sound investment approaches to adopt? Momentum is everywhere.[i] It is because there are two types of momentum investing: implicit (the one we don’t like to admit) and explicit (which we find in academic literature and employed by various quant firms). Explicit momentum strategies are the polar opposite of their implicit counterpart. They are systematic, rules-based, unemotional, persistent and diversified. Everything implicit momentum strategies are not.
People often question why there is a premium for systematic momentum strategies. Perhaps because their profits are the other side of the losses made by ill-judged and widespread implicit momentum strategies. Bad momentum strategies feed good momentum strategies
Implicit momentum, or what we might call performance chasing, is endemic and entirely understandable. Not only are we hardwired to invest in assets that are performing well and sell those that are struggling, but the asset management industry also compels it – all our short-run incentives are aligned to behave in this way.
There is nothing wrong with momentum investing, but there is plenty wrong with adopting an investment strategy that we won’t acknowledge to ourselves or anyone else.