Many investors follow momentum-based methods or approaches when investing in equities, but does momentum investing actually work and what are the results? This is the basis for a recent AAII article by Charles Rotblut, CFA, vice president at AAII and editor of the AAII Journal.

Relative price strength, which compares the price performance of a security to another security or the overall market or an industry, is one of the most popular ways to identify stocks exhibiting momentum. A higher relative strength, with 100 being the highest, equals more momentum and better relative performance.

Since the early 1990s, academics, such as a Eugene Fama and Kenneth French, have been studying risk factors, or the performance drivers, within the stock market. In 1993, Narasimhan Jegadeesh and Sheridan Titman, in their academic study, “Returns to Buying Winners and Selling Losers: Implications for Stock Market Efficiency”,  showed an “observable pattern of returns related to relative price performance, but also that the performance could not be explained by volatility.” The authors were able to show performance of momentum stocks was not due to a size. Further, as Rotblut explains, this was ” another identifiable anomaly to the CAPM.”

In 1997, Mark Carhart furthered the research on momentum in his work, “On Persistence in Mutual Fund Performance”, and created a four-factor model that included momentum. In his research, he “found that the capitalization of the companies and the one-year price momentum of the stocks invested in by a fund could mostly explain its performance.,” writes Rotblut.

Rotblut asks “Why Does Momentum Work?” and explains the various theories. Some professionals believe that momentum encourages a “herding” like behavior in investors, while others, attribute it to good or bad earnings results. Cliff Asness and his team at AQR say it could be both fundamental and behavioral reasons contributing to momentum’s effectiveness.

The chart below shows the long term performance difference between small and large companies with strong momentum and small and large companies with low momentum. The data is taken from the Kenneth French Data Library. Additional long term research supports momentum’s outperformance as well. James O’Shaughnessy, in his book, “What Works on Wall Street”, showed that “stocks with relative strength in the top 30% or higher had annualized returns of approximately 12% or higher versus 10.5% for his all-stock universe. O’Shaughnessy’s data is for the period of 1927 through 2009.”

But like any factor, there are risks and downsides to a high momentum approach. As Rotblut points out, because there are stocks constantly moving in and out of momentum bands, turnover, or many stocks coming in and out of the portfolio, may be an issue. Furthermore, momentum can go through periods of not working. In a working paper by Kent Daniel and Tobias Moskowitz, the authors show there can be periods of time in the market, particularly after major declines, where the effectiveness of following high relative strength stocks doesn’t work and the laggards dramatically outperform the momentum names. To counteract some of the pitfalls with momentum, Rotblut discusses combining value factors, or strategies, with momentum. The two approaches tend to be uncorrelated with each other, which may help smooth the returns of a portfolio holding both types of stocks.