If you’ve ever studied finance in a university setting, or read the academic literature, you’ve almost certainly been exposed to the Efficient Market Hypothesis.
 
And if you believed the Efficient Market Hypothesis, you would have to believe that momentum trading strategies cannot work, at least not consistently or in the long run.
 
But the actual empirical evidence, against all logic, suggests that momentum strategies do work, or at least, that they have worked for very long periods in the past.
 
What is Momentum
Momentum is the name given to the observation (or the hope) that assets that have gone up recently will continue to go up, and that those that have gone down recently will continue to go down.
 
Finding and identifying momentum is not as easy as, for example, “It went up yesterday, therefore it will go up today.”
 
As far back as 1993, in the academic literature, Narasimhan Jegadeesh and Sheridan Titman published Returns to Buying Winners and Selling Losers in the Journal of Finance. They found that, on average, stocks that had done well in the past year were more likely to continue doing well than stocks that had done poorly.
 
But investors have recognized, and profited from, momentum for far longer than that. For example, Dunn Capital Management, operating out of Stuart, Florida, has been investing successfully using momentum strategies since the mid-1970s. (This is not a promotion of any specific investment strategy.)
 
Why Momentum “Shouldn’t Work”
The US stock market is a very competitive environment. Every day, thousands of the brightest minds in the world scrutinize the stock market, looking for opportunities to earn more than the average return in the market.
 
Momentum “should not” work because anyone can see how a stock has been performing. If everyone can see that the stock has gone up, it should only take a relatively small number of people to buy that stock, and push its price up to the point at which it will not continue to go up.
 
Similarly, if a stock has been doing badly, it should take only a relatively small number of people selling that stock, or selling it short, to push the price down to a point at which it will not continue to go down.
 
And yet, across many markets, and across many decades, it appears that momentum has worked, and continues to work.
 
Why Believe that Momentum Works
If you have ever had the personal experience of watching a stock go up, and then bought that stock, only to see it flounder or go down, you might be skeptical of the idea of momentum. From a business point of view, we (Sterling) don’t have a dog in the fight. That is, we’re not in the business of investing, and we don’t promote any particular investment strategy.
 
Nevertheless, momentum is surprising, and there seems to be quite a bit of evidence that it works. Here is some of that evidence, in brief.
 
The above-mentioned paper by Jagadeesh and Titman found that for holding periods of about 6 to 12 months, they (on paper) earned profits of about 12%.
 
Bruce Grundy and Spencer Martin, in a 2001 paper published in Review of Financial Studies, found “momentum profits are remarkably stable across subperiods of the entire post-1926 era.” The paper is titled Understanding the Nature of the Risks and the Sources of the Rewards to Momentum Investing. I studied with Bruce Grundy when he was at the Stanford Graduate School of Business in the 1980s. He’s a very smart guy.
 
Cliff Asness, another super-bright guy, and an extremely successful money manager, along with several colleagues, published a paper titled Value and Momentum Everywhere in 2013 in the Journal of Finance. The paper reported significant momentum effects in a number of markets, including international (i.e. non-US) equities, commodities, government bonds, and currencies.
 
We don’t understand why momentum works, but it sure seems to.
 
Gotcha!
You knew there had to be a gotcha, right?
 
There is.
 
Momentum strategies are mostly effective over periods of less than two years, and often over periods of less than one year. That is, you might be long on an asset for six months, make money, but then have to sell it and buy something else.
 
That kind of strategy produces mostly short-term gain.
 
Short-term gains are taxed at approximately 40% at the federal level, and even higher in most states.
 
Having your investment returns fully taxed at 40% every year puts a real and significant break on compounding.
 
But there is a solution.
 
Solution
One solution is to have your high-turnover momentum strategies in a tax-exempt Active Trading Trust.
 
When appropriate, an Active Trading Trust allows the client – or the advisor – to sell the stock, pay no capital gain tax, and reinvest in a diversified portfolio. It also often allows an advisor to convert a non-AUM asset – the client’s concentrated position – into managed AUM. This solution is very similar to our Stock Diversification Trust for concentrated stock positions.
 
To learn more about how you can use an Active Trading Trust for your clients, please call 703 437 9720 and ask for Connor or Katherine, email [email protected], or click here to request a free copy of our Sterling Advisor Guide: Concentrated Stock Positions.