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Befriending the Trend

April 2016

Trend-following investing may not necessarily work for every investor at all times, as there’s always the risk of timing a buy or sell incorrectly. By Fareem Chagla and Joachim Klement

“An object in a state of uniform motion tends to remain in that state of motion unless an external force is applied to it”

Momentum Investing is best explained by Newton’s First Law of Motion. With a clear lean towards technical analysis in the perennial tiff between fundamental and technical analysis, momentum investing echoes the mantra of ‘Buy High, Sell Higher’. It reflects a strategy by investors and traders aiming to capitalize on the continuance of an existing trend in the price of an asset, with the underlining belief that ‘Winners will be Winners and Losers will remain Losers’. A momentum investor will generally take a long position in an asset that has shown an upwards trend in the past or short sell a security that has been in a downtrend hoping to ride the trend.

Acknowledging that the financial market in itself is a complex web making it difficult to pick winners, sectors or stocks (goes beyond just equities), momentum investing advocates an investor would rather do well adhering to a system which could identify market leaders or laggards. Ideally, it is essential to reliably identify the same based on performance over the last 6-12 months. Stocks that have gone up the most are said to have positive momentum and are believed to outperform in the near future while those with the worst returns have negative momentum and would be expected to continue their slip.

As economic cycles shorten and volatility increases, it becomes imperative to analyze this method of investing in the ‘new normal’. Commentators advocating this way of investing underline it as being one of the most flexible and dynamic investing strategies – for this class of an investor, asset type does not take center stage; instead, what one focuses on is performance. Thus, in times like these, a momentum investors takes refuge in the fact that they can willfully switch asset classes, stocks, commodities, currencies, bonds, REITs or anything else that has been hogging the limelight over the last few months. In the current scenario, that could mean him investing in gold and expecting it to continue its outperformance in the coming months.

Momentum investing, however, does not come for free. The flexibility of momentum strategies can lead to excessive trading costs if momentum signals are designed to switch quickly from one asset to another. Day trading and other very short-term momentum techniques tend to underperform the overall market by a wide margin especially in less liquid assets where trading costs may be much higher than the profits that can be expected from a short-term momentum investment. Generally, the best time-frame to profit from momentum effects are investments that are based on the performance of an asset during the last six to twelve months and held for one to three months.

Another risk of momentum investing are so-called momentum crashes. Trend following investment strategies tend to work most of the time – until they don’t. Financial markets sometimes change direction very quickly. Take for instance the crash in October 1987 when US stock markets fell by more than 20% in one day without any real warnings. Similarly, stock markets started to recover very quickly at the end of the financial crisis in March 2009. Most traditional momentum strategies lost all their outperformance from the previous ten years in the two months from March to May 2009 because the defensive stocks that had held up reasonably well during the financial crisis suddenly were outshined by the bank stocks and real estate stocks that started a strong rally.

Recent research by Prof. Didier Sornette from the Swiss Federal Institute of Technology, however, might provide some remedy against these momentum crashes. His research indicates that momentum investors are better off combining momentum with acceleration. Acceleration measures the change in momentum over two subsequent time periods. An investment has positive acceleration if momentum is stronger in the second period than in the first and negative acceleration if momentum is weaker in the second period than in the first. Investors want to look for assets that show positive momentum and positive acceleration, i.e. situation where the price is moving higher and the returns get bigger and bigger over time. At the same time investors want to avoid assets with negative acceleration where momentum is getting weaker over time. It is these assets that seem most vulnerable to crashes.

So Newton’s first law of motion holds true for financial markets as well, but investors should be aware that, just like in physics, there is always a chance that the impact of other forces may lead to a change in direction. Investors who are trying to exploit momentum effects have to be on the lookout for techniques that mitigate the negative effects of sudden changes in direction. With the techniques explained here this might just be possible.

*Joachim Klement is a trustee of the CFA Institute Research Foundation

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