The Trend is Your Friend: Understanding Momentum Investing

When presented with the question, "What is the best way to invest?", you'll likely receive a variety of answers reflecting the diverse philosophies and strategies that exist in the world of investing. One approach that has consistently demonstrated its efficacy and continues to enjoy widespread popularity is factor-based investing.

Factor-based investing lives in the space between active and passive investing, with the goal of enhancing returns or managing risk by placing emphasis on specific investment factors. These factors, or characteristics, have been identified through rigorous academic research and empirical evidence as consistent drivers of return.

One such factor is momentum, which on market trends and investor psychology, aiming to capture the inertia that is inherent in the market. It involves investing in companies that have shown a recent trend of outperformance, under the assumption that these companies will continue to perform well. Here's all you need to know about the momentum factor.

A recap of factor investing

Among the six widely recognized investment factors, we have:

1. Dividend Yield: This approach focuses on generating excess returns from stocks whose dividend yields are above average, thereby indicating a potential for steady income.
2. Low Volatility: The low volatility factor targets securities that demonstrate stable earnings and present lower risk compared to the broader market, thereby aiming for steady growth with limited downside.
3. Quality: The quality factor prioritizes stocks of companies with stable profits, consistent cash flow, reasonable leverage, and better relative credit quality—characteristics indicative of their financial health and resilience.
4. Value: This approach identifies lower-cost securities that appear undervalued relative to their intrinsic value, offering the potential for significant returns once the market recognizes their true worth.
5. Size: The size factor captures the tendency for smaller companies to outperform larger ones in terms of relative returns, offering a potentially rewarding, albeit higher risk, area of investment.
6. Momentum: This factor seeks companies with improving fundamentals and a recent history of outperformance, which may continue due to market trends and investor behavior.

Today, we're delving deeper into the last factor, momentum. But what drives momentum? And how can investors successfully apply this strategy in their portfolios?

What is momentum?

The principle behind momentum investing is both powerful and deceptively simple: "buy high, sell higher." It may seem counterintuitive to those accustomed to traditional value investing principles, but the momentum strategy involves systematically buying assets that have recently outperformed in the market, in the belief that these assets will continue to rise in value.

At its core, the momentum effect is rooted in the observation that securities that have performed well in the recent past, typically from three to twelve months, tend to continue to perform well in the near future. Similarly, securities that have performed poorly over the same time horizon often continue to underperform. In other words, sustained trends either way can form and persist.

The momentum effect can be seen across various asset classes and in markets around the world, making it a pervasive phenomenon that is not confined to specific geographical regions or types of investments.

What causes momentum?

Momentum investing capitalizes on patterns in investor behavior. According to behavioral finance, investors tend to underreact to new information about a company or market, causing price adjustments to occur slowly over time rather than all at once. As more investors gradually react to the news, the price continues to move in the same direction.

Investor behavior also tends to exhibit a 'herd mentality' where they follow the investment decisions of other investors, creating a cascade effect that propels stock prices. These behavioral biases contribute to the momentum effect. Also known as "FOMO" (the fear of missing out), investors often pile into hot stocks, which can help a momentum strategy win.

Momentum has historically resulted in out-performance versus the broader market. For example, from January 1, 2002, to February 28, 2022, the benchmark S&P 500 index returned an annualized 9.0%. Meanwhile, the corresponding momentum factor returned an annualized 11.8%, highlighting its power.

How to invest in momentum

As a factor, momentum is typically calculated using a straightforward measure: the total price return of a stock over a specified period of time. The 'lookback' period can vary, but a common choice is the trailing 12 months.

Investors who use the momentum strategy systematically rank stocks based on their past returns and then invest in the top performers. They periodically reevaluate and adjust their portfolios, selling stocks that lose momentum and buying those that gain it. The goal is to be as objective and unemotional as possible, with a focus on risk management.

In essence, momentum investing revolves around the adage "the trend is your friend." By identifying and riding the trends in the market, momentum investors aim to profit from both the upside and downside of market movements. However, identifying this trend isn't always easy, and can require sophisticated tools and knowledge.

Why use an ETF for momentum investing?

A momentum ETF allows investors to gain exposure to the factor via a professionally managed, disciplined, and rules-based instrument. These ETFs handle the heavy lifting when it comes to quantitative analysis, portfolio management, and trading, which can save investors significant time and money, and produce better risk-adjusted returns.

CI GAM's suite of momentum ETFs track the various Morningstar® Target Momentum Indices. Hallmark of these indices is a rules-based screener that systematically ranks eligible stocks based on several factors, including an above-average return on equity, upwards earnings estimates, and technical price momentum indicators.

Currently, our lineup encompasses three options, all of which equally-weight their holding and rebalance quarterly to ensure targeted exposure to momentum:

• CI Morningstar Canada Momentum Index ETF (ticker symbol WXM)
• CI Morningstar US Momentum Index ETF (ticker YXM for CAD-Hedged; YXM.B for Unhedged)
• CI Morningstar International Momentum Index ETF (ticker ZXM for CAD-Hedged; ZXM.B for Unhedged)

If you're looking to make the trend your friend, consider making one of CI GAM's momentum ETFs a candidate for inclusion in your investment portfolio.