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Because Markets Change - 3 Myths About Momentum Investing

Newton’s first law of motion states that an object in motion stays in motion. And many studies have found that stocks and mutual funds also experience momentum. Momentum investing strategies, like our own Upgrading strategy, attempt to take advantage of momentum by seeking out funds that have strong near-term returns and avoiding funds with weak near-term returns. 

There are many misconceptions about momentum strategies—that momentum doesn’t have a very long history or that trading costs and taxes will eat into any potential gains. But a May 9, 2014 paper, “Fact, Fiction, and Momentum Investing” by a group from AQR Capital and the University of Chicago addressed some of these common myths. 

Myth: Momentum investing is new.

Fact: Momentum has a much longer history than most investors realize. 

“Fact, Fiction, and Momentum Investing” noted that, “The existence of momentum is a well-established empirical fact. The return premium is evident in 212 years (yes, this is not a typo, two hundred and twelve years of data from 1801 to 2012) of U.S. equity data….Some of this evidence predates academic research in financial economics, suggesting that the momentum premium has been a part of markets since their very existence, well before researchers studied them as a science.”

Myth: Any gains from momentum will be eaten up by trading costs.

Fact: Momentum investing overcomes trading costs.

Trading costs do eat into returns, but in today’s world where many funds are available without transaction fees, costs are often nominal. And the report found that costs could be overcome by excess returns.  

The authors of “Fact, Fiction and Momentum Investing” put this to the test “using a unique dataset containing more than a trillion dollars of live trades from 1998-2013 across 19 developed equity markets.”  They found that “per dollar trading costs for momentum are quite low, and thus, despite higher turnover, momentum easily survives transaction costs.”

Myth: Momentum investing isn’t tax efficient.

Fact: Momentum investing can be “tax advantageous”.

Perhaps the most common myth about momentum investing is related to taxes. Momentum strategies tend to have higher turnover than other popular investment approaches, but “Fact, Fiction and Momentum Investing” explained that “high turnover does not necessarily equal high taxes.”

In fact, the authors found that “momentum actually has turnover that is biased to be tax advantageous—it tends to hold on to winners and sell losers—thus avoiding realizing short-term capital gains in favor of long-term capital gains and realizing short-term capital losses. From a tax perspective this is efficient and effectively lowers the tax burden of momentum strategies.”

 

 

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