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Factor investing: what is momentum and how can it be applied?

  • Describe how momentum and sustainability factors work in principle
  • Explain how malfunctioning of the stock market helps momentum investing
  • Identify how sustainability works as a factor in investing
CPD
Approx.30min
Factor investing: what is momentum and how can it be applied?
This article will focus on the last of the five most widely accepted factors: momentum. (Rawpixel/Envato Elements)

In this article, and the wider three-part series, we hope to shine a light on factor investing, explaining some of the background, key concepts, and drivers behind this investment style.

In the previous articles, we outlined how factor investing is an investment approach that involves targeting quantifiable characteristics or ‘factors’ that can explain differences in security returns.

Having explored the quality, minimum volatility, size and value factors, this article will focus on the last of the five most widely accepted factors: momentum.

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We will also delve into the topic of sustainability, including how this can be incorporated as part of a wider factor-based approach, and recent regulatory developments in this area.

The momentum factor is the tendency for assets that have performed well in the recent past to continue to perform well in the future, at least for a short period of time.

Momentum tends to look at a stock’s last 12 months of price movements, excluding the most recent month, with stocks assigned a momentum score based on how strong or weak their returns are.

The momentum factor itself is typically seen as an anomaly, as Eugene Fama’s efficient markets hypothesis suggests that there is no reason for a security’s price to keep increasing (or decreasing) in value following an initial increase (or decrease) in value.

Empirical evidence covering the momentum factor was first published by Narasimhan Jegadeesh and Sheridan Titman in their paper "Returns to Buying Winners and Selling Losers" (1993), in which they demonstrated that stocks that had outperformed in the medium term would tend to continue to perform well, and vice versa for stocks that had underperformed.

This was followed by Mark Carhart’s seminal study "On Persistence in Mutual Fund Performance" (1997), who used the momentum factor together with Fama and Kenneth French's three-factor model to explain mutual fund returns.

This 'fourth' factor increased the explanatory power of returns, and the four-factor model became a widely accepted model in explaining investment returns.

The rationale for behind why the momentum anomaly exists has been the subject of much debate, however the academic literature focuses on investors' behavioural traits, namely investor under-reaction or delayed over-reaction.

Under-reaction occurs when investors under-react to certain types of financial news. For example, a company may announce strong quarterly earnings, and while the market may push the stock price higher in reaction to this, it does not go high enough.

As such, over the coming weeks the price may drift upwards as the market fully absorbs the information provided through the quarterly earnings.

An investor who bought the stock immediately following the announcement could benefit from this effect, before then selling ahead of a downturn in the stock price.

On the other hand, delayed over-reaction results from investors who chase returns, providing a positive reinforcement loop that serves to drive prices further above those suggested by their underlying fundamentals.