Five perils of momentum investing you cannot ignore

At Capitalmind, we have been working with factor-investing and momentum in particular as a long-term investment strategy in different shapes and forms since 2015. Our current avatar of momentum has been around since 2018, albeit with tweaks along the way. We were and probably still are the only PMS in India to offer a Momentum Strategy in the Capitalmind PMS since early 2019. The AUM in this strategy has grown by 14 times, on a small base of course, over the 26 months since launch.

We published an SSRN whitepaper on the historical persistence of momentum in Indian equities that has since got a surprising amount of interest.

The Capitalmind Momentum smallcase, a portfolio built on the same principles, with some differences from the PMS, is apparently one of the more popular smallcases on the platform according to a CNBC segment. Surprising, considering we only offer one smallcase unlike most other managers on that list who offer several different variations.

Momentum investing has gone from being the slightly weird friend at the party few want to talk to, to being the center of attraction.

Sensing the general euphoria, a few months ago we wrote about five things to consider before subscribing to a smallcase as a note to help form realistic expectations.

Equity investments and equity markets are not inter-changeable

Recently someone pointed us to a popular youtube channel (with no connection to us whatsoever) that “reviewed” our momentum portfolio with the host saying he expects a strategy like this to deliver double-digit returns. Per Month.

So here are five perils of momentum investing that new investors need to consider, whether already invested, or considering the plunge:

Momentum is High churn

For investors with experience in equity investing using traditional bottom-up fundamental methods, momentum investing can feel like a lot of buying and selling. This activity can increase in higher volatility years like 2020. Even in regular times, momentum strategies, depending on how they are designed, will replace between 10 and 20 percent of their portfolio each month. This translates to completely changing the portfolio anywhere between 2 and 4 times a year. This adds an incremental element of costs, especially if you use a full-service brokerage. Even with low-cost brokers, you still bear the STT when selling stocks. Also, this means all your gains are taxed at the Short-term Capital Gains (STCG) rate of 15 percent versus 10 percent Long-term Capital Gains (LTCG).

Momentum investors have to get used to being “wrong”

Did you know that half of the stocks picked by momentum strategies exit with losses? The traditional method of picking individual stocks after careful research does not apply to Momentum Investing. It is a portfolio strategy that picks a set of stocks based on quantitative price and volume criteria. And as many as 50 percent of stocks that enter the portfolio don’t make gains.

Momentum investing, at the portfolio level is meant to make decent returns by not losing too much on the ones that do lose.

But the idea of buying a set of stocks to see half of them go in the opposite direction than intended can cause a lot of discomfort to some folks. It’s like a student used to seeing only tick marks on her answer sheet having to get used to seeing crosses as well. That’s not for everyone.

Momentum portfolios will often hold “ugly” stocks

Good business = Good stocks. That’s the most common investing narrative. So we expect to see HDFC Bank, Bajaj Finance, Britannia, Nestle and so on in our portfolio. In our minds, their price movements are obviously the market being the unpredictable irrational being it so often is.

But momentum investing does not care about pedigree. It buys what meets a set of objective criteria. And some of those stocks and companies look ugly, especially in retrospect. So a Vakrangee might make the cut to be in the portfolio. More recently, the Adani stocks found their way into a lot of momentum portfolios. You might ask, why not check corporate governance?

To that I repeat the example of Satyam Computers, a NIFTY stock in 2008, it was awarded the Golden Peacock award for corporate governance in September 2008. And on January 7, 2009, its founder published a letter admitting to massive accounting fraud. Like with a lot of things in life, the difference between the good and the bad is only apparent in hindsight.

Momentum will get written off

Momentum will have indifferent periods. At that time, obituaries will get written about this ridiculous method of investing along with a lot of “told you so”. It’ll be hard to stay invested when this happens.

Momentum will underperform

This brings me to the bad news. Momentum strategies will underperform from time to time, especially in the short term. Just like any and every equity strategy underperforms for different periods of time. If they didn’t they would be called “Holy Grail” strategies and there aren’t any that we know of.

To put this is in relatable terms, we backtested our momentum implementation of a 15-stock portfolio rebalanced monthly.

This means at any given time, there’s a 36 percent chance of your 1-year return trailing the NIFTY. That’s more than a 1 in 3 chance. Yes, that chance reduces as your time horizon increases, like by staying invested in the Capitalmind momentum strategy, you stand a pretty good chance of coming out ahead of the NIFTY. Again, this is what the past tells us, the future might not be as kind.

This is essential to understand for those who think of momentum as a “short-term” play and are surprised to find it trailing the index over a couple of weeks or months. And those entering the strategy with that expectation will experience significant discomfort.

Quoting from a recent post by Joe Wiggins in his post “What are the 10 biggest mistakes made by fund investors?”

If there was one thing that could be done to improve the decision-making of fund investors it would be to extend our time horizons. The shorter our timescale the more we are captured by chance; consistently making judgements based on random and unpredictable market movements.

You’re hosting a friend with who you discuss stocks now and then. It’s been a while since you caught up. As you clink your cut-glass tumblers, he fills you in on his recent investing exploits. About how he identified a company at the bottom of a cycle with a runway ahead for 4 times earnings growth courtesy of its move into blue-ocean space with significant pricing power.

Imagine countering that with “Bought a bunch of stocks because their prices were rising”. He might not react. Or he might raise one eyebrow slightly. You know he’s thinking whether the lockdowns have finally taken their toll on you.

A definite side-effect of being a momentum investor is to not have deeply enriching theses to share about the stocks you own.

Certainly not for everyone, this momentum investing.