Riding momentum is a key trait for all successful investors
In a previous job I was lucky enough to sit right next to a dealing area for a major broking firm.
It certainly added some excitement to each day in the office to see how these experts handled buying and selling seriously hefty trades in various companies, how they saw market conditions and also how they handled their own personal trading when they had some spare time.
One who I remember very well was a momentum trader who would notice a rising price and/or volume trend in a stock in the morning, load up on their shares and see how far he could ride the trend.
To an essentially buy and hold shareholder with a value bent such as myself, it was amazing how little he knew, or wanted to know, about the company he was buying shares in.
Does research work?
“Researching what they do is just a waste of time – I just want to get on the rising trend and then get off before I give those gains back to the market.’’
What this broker was doing was essentially a form of momentum investing, a label given to an approach that uses the inertia of a price trend to continue for a period of time.
In his case that period was effectively a trading day – by the close of trade he was out of the stock and was either in a chilled, expansive mood or was annoyed at what might have been if things had worked out differently.
However, momentum investing using some combination of price and or volume can make money over much longer time periods and can also be used for price falls as well as rises.
All great investors use momentum
When you think about it, all of the great investors have an element of momentum investing about the way they operate.
Even Warren Buffett, whose roots are deeply in value investing, is also exceptionally good at seeing an early trend and riding it for a very long time.
His early investments in five giant Japanese trading houses, electric car maker BYD in 2008 and even his classic purchase of Coca-Cola shares way back in 1988 were all inspired acts of momentum investing.
Momentum plus capital can equal massive returns
In every case Buffett was early to recognise a rising trend and backed it with big chunks of capital to produce such a large return that it made a significant difference even to a monster $1.4 trillion investment company like Berkshire Hathaway.
In the case of Coca-Cola, spending more than US$1 billion to grab a 6.2% stake in the drinks giant was a seriously big deal in 1988.
Some of those trades are still going for Buffett’s Berkshire Hathaway, although he has sold down some of the BYD stake at a very handsome profit as it emerged to become a major player on the world automotive scene.
Buffett also has the quite unique ability to bring momentum to a company simply by his presence given his lengthy track record, although even Buffett has had failures which he is always happy to reveal in his folksy shareholder letter.
Index funds are really mechanised momentum traders
Even passive exchange traded funds (ETFs) that mirror an index such as the ASX 200 are really mechanised momentum traders, constantly selling down shares that have fallen and buying more of those that are rising and, in the process, producing a performance that most active investors really struggle to keep up with.
How to automate momentum approach
Given the impressive track record of momentum investing of all types it was perhaps inevitable that an ETF provider would look for a way to systemise a momentum approach and turn it into a product.
Local ETF producer Betashares recently released its Australian Momentum ETF (ASX: MTUM) which aims to invest in a portfolio of Australian companies that are showing strong momentum and outperforming other stocks.
It does this through a fairly involved index process.
MTUM’s index ranks 200 of the largest stocks on the ASX by their 6 and 12-month risk-adjusted returns and selects the top 50 stocks based on those rankings at each selection day.
It repeats this selection process every two months.
The final portfolio is made up of the top 50 stocks selected on each of the last four selection days. This typically results in a portfolio of around 90 stocks with a mix of partial and full weighting allocations depending on how consistently each stock has ranked in the top 50 over the four selection days.
Any stock that is ranked in the lowest 10% based on its 6-month total return at the latest selection day is removed from the final portfolio.
It is early days yet but the index methodology is meant to be purely rules-based, prioritising stocks with strong and consistent momentum, while cutting the worst performers quickly.
That gets rid of human bias and is one method of beating the ASX 200 index and adding some more momentum to your investments.