The momentum factor is an investment strategy that targets stocks exhibiting strong recent performance, buying those that have gone up and selling or avoiding those that have lagged, based on the principle that trends tend to persist. This tendency is often linked to insights from behavioural finance, suggesting that investor psychology — such as herd mentality, overreacting to news, or anchoring on past performance — can cause price movements to persist longer than fundamentals alone might justify.
By systematically ranking stocks based on recent returns and adjusting holdings accordingly, momentum strategies aim to capitalize on these behavioral biases in an unemotional, rules-based way.
Momentum can be effective in both rising and falling markets:
- In upward-trending markets, momentum strategies typically maintain exposure to stocks demonstrating sustained price strength — following the principle of “buying strength and selling weakness.”
- In downward-trending markets, they may reduce exposure to or short underperforming securities. This strategy is pursued because shorting involves borrowing a security and selling it immediately, with the expectation that the price will drop. If the price declines, the investor can buy the security back at a lower price to return it to the lender, thereby profiting from the difference between the initial sale price and the repurchase price. By doing this, they are seeking to benefit as prices continue to decline.
Complementing Value Investing
Momentum and value investing are often seen as opposites but can work complementarily within a portfolio. While value investing focuses on finding undervalued companies trading below what appears to be their intrinsic worth and seeking long-term appreciation as the market corrects mispricings, momentum investing, on the other hand, targets securities already showing a clear price trend. This trend-following strategy aims to capitalize on short- to medium-term price persistence, whether the security is exhibiting strength (positive momentum) to buy, or weakness (negative momentum) to sell or short, believing that the existing direction will continue.
When combined, these approaches have the potential to enhance diversification and risk-adjusted returns. Value strategies tend to perform best when market sentiment normalizes and fundamentals matter most, while momentum strategies thrive during strong market trends — both upward and downward. This balance may help portfolios adapt to different market regimes.
Dynamics During Index Rebalances
Index rebalances — when indexes periodically add or remove stocks based on market cap or other criteria — create shifts that can affect momentum strategies. Most major indexes, like the S&P 500*, are market-cap weighted. This means that stocks that have recently performed well and grown in market capitalization get added or increase their weighting, while underperformers get removed or reduced. This creates a “buy high, sell low” dynamic. Since momentum stocks are often the high-performing “winners,” they are added to the index, causing a surge in demand from passive index funds that must now buy them. Conversely, underperforming stocks are sold off, often with a significant price dip.
The Reversal Effect
The reversal effect can create contrarian investment opportunities as it signifies a correction in short-term price movements. Stocks that are added to an index often experience a price boost as index-tracking funds buy them, but this demand can sometimes push the price beyond its fundamental value, leading to a subsequent reversal known as a reversal effect. Similarly, stocks removed from an index may be oversold and may offer an attractive entry point for value investors who believe the company is now undervalued.
Momentum-based indexes tend to have a higher turnover rate than value or broad market indexes because the list of stocks changes more frequently. This requires frequent rebalancing to maintain the desired factor exposure. This higher turnover can lead to increased trading costs, which can eat into returns.
The momentum factor captures the power of trends — both positive and negative — rooted in investor behavior and market psychology. When paired thoughtfully with value investing, it can create a more balanced and adaptive investment strategy, capable of navigating a variety of market conditions and shifts caused by index rebalances.
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