The Case for Momentum Investing
Momentum is the single largest inefficiency in the market
– Jeremy Grantham
Relative strength or momentum is the tendency of investments to persist in their relative performance. In other words, investments that have performed well tend to continue to perform well; those that have performed poorly tend to continue to perform poorly. It is one of the reasons investors struggle to sell at the top or buy at the bottom.
Momentum is a unique anomaly that applies across all asset classes. Academics have defined two types of momentum that can be applied to investments: relative momentum and absolute momentum. Relative momentum is one asset’s performance relative to other asset classes. Absolute momentum can be defined as using a single asset class’ past performance to predict its future performance; it is not relative to other asset classes. Studies have found that using both relative and absolute momentum can enhance investment performance but that using absolute momentum on its own can reduce portfolio volatility.
While the historical evidence for momentum is pervasive (nearly 300 academic papers have been published since 1990), the underlying root causes remain uncertain. Some argue that momentum is due to under-reaction by some investors to new public information. Others argue that volatility leads to overextensions of both good and bad price trends. Another explanation is that investors are prone to what behavioral economists call the disposition effect—which is the tendency of investors to sell winning investments too early to lock in gains, and hold on to losing investments too long in the hope of breaking even.
Rationalis Capital Management will utilize relative strength/momentum to add alpha to our portfolios in two distinct ways. First, we will continually monitor the performance of all the asset classes that we use in our portfolios. On a quarterly basis we will then add one or two of the best performing asset classes to our satellite portfolios. Second, we have focused on both relative strength/momentum and volatility in our proprietary trading models and created signals for both entry and exit points which we believe will lead to better risk adjusted returns in all economic environments.