My Journey in Finance: Why Momentum Works

In this new series of articles, My Journey in Finance, I wanted to explain why the ByteTree investment process is what it is. It is built on personal experience, having begun my investment journey as an amateur in 1992 and professionally since 1998. In that time, I have come across many different companies, cycles, investment approaches, funds, services, market conditions and theories; some of them were good, but most were bad. If there is one thing I have learned above all, there are no quick fixes in finance. In this series, I will go through some of the lessons I have either personally experienced or witnessed, and share what I learned from them.

I latched onto the momentum effect around 2001, having completed my training in technical analysis in 1999 with the UK Society of Technical Analysts (STA). I came to realise there was much more to historical price data than meets the eye. Some investors have used charts with great success with tools like momentum, trend-following and pattern recognition. They succeeded where most failed because their objective interpretation increased their odds rather than reaffirming a personal bias. People see what they want to see.

A key point about charts is not just the study of a single asset, but how that asset compares to other opportunities in the market. For example, a rising trend is normally a good thing, but if that trend is rising at a snail’s pace, then don’t expect magic to happen. Better to find trends that are not only rising but beating the market to boot. Hence the momentum effect doesn’t just focus on trends, but the strongest trends. This is what differentiates momentum investors from trend followers.

Using a football analogy, it is obvious that a good striker will continue to score more goals than a player selected at random. But then the striker becomes worth millions in the transfer market, and whether they score enough goals per million is another matter. Given the games result in a win or a loss, what does it matter? The winning teams need the best players, so the team owners just pay up. Great footballers are valued at their marginal edge, which makes them a price-inelastic luxury good.

It's the same in momentum stocks. The best advertising strategy for an investment is a rising price. The longer they keep going, the more the excitement builds, and the result is always euphoria. Momentum investors are hunting for euphoria.

The idea is that if you own the strong trends, you’ll sooner or later stumble on success because it is guaranteed to own the winners, provided the strategy’s implementation owns the stocks that are going up the fastest. That makes it sound easy, which it isn’t because new trends come and go every day, and it takes a lot of trading to own the winners. If you don’t own the ones you dislike, the chances are that they’ll be the ones that fly. If something can go wrong, it probably will. In bull markets, there are lots of stocks that are rising, so focusing on the ones that aren’t just rising but outperforming is key.

This global momentum index from MSCI came to market in 2014. On occasion, The Multi-Asset Investor has held the ETF that tracks it. Pre-2014 or so, the index is a backtest, meaning it wasn’t validated with real portfolio performance. Like most backtests, it’s good, honest data, but the further you go back in time, the harder it gets to understand what actually happened in the market.

The Momentum Effect

I would suspect the index suffers from “survivor bias” that overstates the success of past returns. For example, we know that momentum crashed in 1973/4 because it’s written in the history books. Yet, according to this index, the underperformance versus the index was a mere 10%. I believe that is understated, but that doesn’t mean that we should dismiss it; just add a bit of healthy scepticism.

The momentum effect may have delivered 2.8% more per annum than the market, but that is front-loaded, with most outperformance delivered pre-2000. Using this data, excess returns were around 3.5% p.a. from the 1970s to 2000 and 1% since. There are two reasons why the outperformance could have fallen. The first is that smart programmers, good data, and computers are readily available these days, so many more investors embrace momentum, making it more competitive. The other, as I alluded to, is that it was overstated back in the day. I’ll meet you in the middle.

In the early noughties, there were many hedge funds engaged in momentum investing based on academic evidence that the leading stocks carried on leading for longer than could reasonably be explained. Yet, few admitted they were trend followers or momentum investors as that sounded too simple and couldn’t command high fees. Typically, they would pitch something involving fundamentals or events, but their performance so often resembled that of a trend follower. As you can imagine, they were soon found out.

Be in no doubt, I am a big fan of the momentum effect and find it fascinating. But as you’ll soon learn, I have become much more cautious about it than I once was, and that has reshaped my investment approach. I still embrace the market trends, but not so slavishly and with much more caution. There’s so much more to say on this, so next week, we’ll build a global equity momentum fund.

A Week at ByteTree

In The Multi-Asset Investor, I covered the recent stimulus package in China. This means we should be prepared for China to float its currency, and, over the long term, it’s another reason to be cautious about bonds and bullish on gold.

In Venture, there was the monthly portfolio review with some sales and a new note on an opportunity in the palladium market.

Finally, in ByteFolio, I highlighted that Bitcoin, having made a higher high at the end of September, also made a higher low last week. That could mean a bullish change in the trend.

Have a great weekend,

Charlie Morris
Founder, ByteTree