Stock price momentum is simply this: a stock that has gone up has positive momentum, and a stock that has gone down has negative momentum. At its most straightforward, investors can construct a momentum portfolio by buying the top 25% of stocks that have gone up over the previous year. Using the S&P ASX 300 as the stock universe, this results in a portfolio of about 60 stocks. Each month, the portfolio is reconstructed using the latest data.
In Australia, this simple strategy has done extraordinarily well over the last three decades. The returns from momentum strategies are so compelling that Australian equities investors should carefully consider how they can best use momentum in their portfolios.
The data above is calculated as follows. All stocks in the S&P ASX 300 are sorted based using yearly momentum, price to book, size, and return on equity (ROE). For momentum, the stocks with strongest positive momentum are ranked highest; for price to book, the cheapest are ranked highest; for size, the smallest are ranked highest, and for ROE the most expensive are ranked highest. The top 25% of stocks are used to construct the portfolios, and the rest are discarded. All stocks in the portfolio are held at equal weight, and the portfolios are constructed every month. Using this simple process, investors in the momentum strategy have outperformed all other factor strategies with a better returns to volatility ratio, and a less severe and shorter drawdown.
While the historical returns for momentum are compelling, as investors we need to be confident that we can expect similar returns in the future. While we can never know for sure, if the underlying drivers of momentum are caused by enduring market characteristics, we can have some confidence that momentum strategies will work in the future. As an aside, investors should apply this rationale to any factor they use. Take value, for example. There is something comforting about buying stocks that are cheap. If they get cheaper, just buy more. However, in Australia investors are not compensated for doing this. You are better off buying the index than a value portfolio based on book value.
We think that the most sensible explanations for momentum are based on human behaviour. We have evolved certain emotional responses over millennia that were appropriate for the environment we were in, but that when applied to financial decision making can lead to biases. To name a few (in no particular order):
There are other psychological biases that might lead to momentum in stocks – the list of biases is a long one. What is clear, however, is that we have evolved to think about risk and reward in ways that are counter-productive when it comes to investing. Supporting this idea is that momentum can be found in multiple markets and asset classes - it is not just an Australian phenomenon.
Over the past three decades, momentum portfolios have had varying performance across different equity markets . Since 1987, momentum portfolios performed best in Australia, Canada, and Denmark, and worst in the Netherlands, Singapore, and Japan. It is difficult to pin down exactly why momentum worked better in Australia than Japan. However, assuming momentum is a result of behavioural biases one place to start is culture.
One of the first individuals to quantify culture was Geert Hofstede. In the late 1960s, while at IBM, Hofstede analysed a large database of employee value scores collected from 70 countries between 1967 and 1973, with the aim to clarify cultural differences across the organisation. Hofstede identified six primary dimensions of culture: power distance (the degree to which people accept unequal distribution of power), individualism (a preference for a loosely knit social network over community responsibility), uncertainty avoidance (how uncomfortable people are with not knowing the future), masculinity (competition is preferred over cooperation), long term orientation (traditions are more important than change), and indulgence (free gratification compared to restraint) . 3
The two metrics which stand out are individualism and long term orientation. Australians and Canadians are highly individualistic cultures. People look after themselves and their immediate families. In business, employees are expected to be self-reliant and display initiative and promotions are based on merit and output. In Japan, harmony of the group is placed above expression of individual opinions, and employees are famously loyal to their employers. Singapore is more collectivist: a person is more a member of a family than an individual, and politeness takes precedent over honest feedback. In Australia and to some extent Canada, people have a relatively small propensity to save for the future, and have a focus on achieving quick results. The Japanese, however, see their lives as a short moment in the history of mankind, and expect companies to serve stakeholders and society for generations.
There is a possibility that these cultural differences could exaggerate or dampen the behavioural biases that can lead to momentum, leading to different momentum profits in different markets. Individualism could lead to overconfidence, and an incorrect belief surrounding decisions. Ignoring evidence that disagrees with one’s investment thesis means that you would be more likely to hold onto losing positions for longer. Momentum strategies do the exact opposite – losing positions are unceremoniously cut. Having a short term orientation could also lead to stronger momentum profits. There is evidence supporting the idea that investors who frequently examine their portfolios are more likely to succumb to behavioural biases. It is these biases that we believe lead to momentum.
Supporting our view that momentum effects can be influenced by cultural factors is a body of academic literature that shows some cognitive biases differ depending on culture. Li-Jun Ji from Queens University in Canada and co-authors studied culture and gambling fallacies. They found that Chinese participants were more likely than Euro-Canadians to believe they could correctly predict a coin-toss following a series of losses, suggesting greater susceptibility to the gambler’s fallacy. In a second study in the same paper, Euro-Canadians were more likely than Chinese to predict outcomes in line with a basketball players winning streak, suggesting greater susceptibility to the hot-hand fallacy (the mistaken belief that winning streaks are likely to continue). In a different study, Chih-Hsiang Chang and Shih-Jia Lin from Taiwan looked at herding behaviour in international markets, and found that participants in different markets exhibit different herding behaviours. Herding behaviour is more pronounced in Confucian markets than Western markets. Another interesting result came from Monika Czerwonka at the Warsaw School of Economics in Poland, who found that culture influenced both anchoring bias and overconfidence. All these are examples in which the cultural background of the participants changes the results – biases are exaggerated or dampened depending on where you come from.
Spending time thinking about why momentum works better in Australia than other developed markets can help us answer this question. We have argued: 1) that momentum works as a strategy because humankind has evolved in a way that can lead to detrimental behaviours when it comes to investing and 2) that different cultural backgrounds can emphasize different behavioural biases. In Australia, our individualistic culture and short-term orientation might play a part in understanding why momentum works so well here. Going forward, if Australian culture changes in a material way and if the majority of market participants make a conscious effort to account for their behavioural biases, then momentum will work less well in Australian equities. We think both of these have a low probability of happening: culture both professionally and personally is established over many generations, and behavioural biases are ingrained in the way we think as a result of millennia of evolution. Changing both will not happen overnight, giving us confidence in using momentum over the coming years.
Often, once momentum is generally accepted as a strategy, investors often consider obtaining their momentum exposure through owning the index as a whole. If a stock goes up more than other stocks, its index weight will increase, meaning that the investor will naturally become more overweight to better performers. While this is true, doing this does not lead to momentum exposure in the way we describe here, and investors will not obtain the improved risk/reward that momentum investing provides. Momentum as a strategy is shown to work using all the stocks in the index – buying the whole index means you are also buying stocks with negative momentum, negating the effect of stocks with positive momentum. The same logic can be applied to value, or any other factor whose existence is justified by splitting the S&P ASX 300 into parts based on a particular metric.
At face value, the returns shown in the table on the first page are compelling. While this is true, hidden behind those returns are some sharp drawdowns that are fast enough and severe enough to prevent some investors from investing in momentum at all.
The twelve month rolling alpha of the momentum signal (shown above) is an example of this, with the most recent example of a sharp drawdown occurring in the fourth quarter in 2016. Even though over the long term investors are better off, mistiming an initial investment would not be pleasant.
Although the bounce back is often as sharp as the drawdown (an important point), when we invest using momentum here at Platypus, we spend as much time on risk control and portfolio construction as we do on selecting the best momentum time periods, or the best combination of momentum signals. We cannot emphasise how important risk control is for momentum strategies – the risk reward for momentum can be improved by taking careful account of risk. Doing this provides investors a smoother ride, with more stable returns.
In order to make momentum investible, we follow a number of steps. First, we apply a screen to our momentum portfolio based on company fundamentals. We prefer stocks that have earnings and that have improving returns on equity. Doing this helps prevent us from buying the dream. Second, we use a risk model that accounts for as best as possible for extreme events. We want to be able to protect as much as we can against periods in which momentum doesn’t work – periods such as Q4 2016 or Q2 2009. Finally, we smooth the portfolio to hedge our risk against buying at exactly the point at which a momentum trend has finished. All these steps together improve the risk/reward of momentum, and in our view are an essential part of investing using momentum.
The evidence for long run positive returns from momentum strategies in Australian equities is compelling, as is the argument for continuation of momentum profits. Investors should consider carefully how they can best use the characteristics of the domestic market to their advantage, while being cognisant of the risks involved.
1 Asness, Clifford S. and Moskowitz, Tobias J. and Pedersen, Lasse Heje, Value and Momentum Everywhere (June 1, 2012). Chicago Booth Research Paper No. 12-53; Fama-Miller Working Paper. Available at SSRN: https://ssrn.com/abstract=2174501
2 See https://www.platypusassetmanagement.com.au/news/indexing-and-factor-investing for more details
3 For more details see https://www.hofstede-insights.com/models/national-culture/
4 Ji L-J, McGeorge K, Li Y, Lee A, Zhang Z. Culture and gambling fallacies. SpringerPlus. 2015;4:510. https://doi.org/10.1186/s40064-015-1290-2.
5 Chih-Hsiang Chang and Shih-Jia Lin. The effects of national culture and behavioral pitfalls on investors' decision-making: Herding behavior in international stock markets. International Review of Economics & Finance. Volume 37, 2015, https://doi.org/10.1016/j.iref.2014.12.010.
6 Czerwonka, Monika. Anchoring and Overconfidence: The Influence of Culture and Cognitive Abilities, International Journal of Management and Economics. Volume 53(3), 48-66, 2017, https://doi.org/10.1515/ijme-2017-0018