Trading Portfolio; Momentum

Beat the S&P 500 index using momentum

Another way to invest successfully in the stock market is to use the momentum factor. Momentum investing is basically buying stocks that have gone up in the recent past and hoping those stocks will continue to go up short term. In a way it is a fashion contest.

Which stocks are popular now and more importantly therefore which stocks will continue to become more popular in the future?

Research has shown that “fresh” momentum works much better than “late” momentum. In other words if you are an early arrival at the momentum party it is a lot of fun, but if you are the last one to show up at the momentum party then you are likely to have a hangover the day after. Hedge funds, active fund managers and quant shops all use the momentum factor. There are a lot of different ways to measure momentum and select stocks on the back of your momentum measure.

One of the downsides of the momentum factor is that the space can get overcrowded and over-positioning can lead to nasty fast and furious sell offs in the most crowded momentum names during which the hedge funds take their stop losses and go back into cash for a little. If investors can sit out those violent corrections, momentum can be a rewarding long term investment strategy.

On the Seeking Alpha app 8 different U.S. equity factors are listed; value, growth, quality, low volatility, high dividend yield, momentum, dividend growth and equal weight. The growth and momentum factor are the only 2 factors in the green as of the 5th of July 2020 in every time frame mentioned on Seeking Alpha (today, 1 month, YTD, 1 year and 3 years). Not surprisingly both factors have also performed best in the last 3 years as a result. Seeking Alpha has the growth factor with the best factor performance with a 3 year return of 51.22% and the momentum factor as the second best factor with a 3 year return of 50.52% for the U.S. equity space.

One of the negatives of the momentum factor used to be the need for a high turnover. The momentum signal gets staler as time goes by. In order to keep the momentum signal strong the momentum signals need to be refreshed and that will lead to the need to update the momentum portfolio with buy and sell orders. The momentum signal is like a fish just caught from the sea. The fish is fresh enough to start with, but that fish will get smellier every day that goes by. Higher turnover leads to higher transaction costs. In the old days commissions were so high private investors could not have easily played the momentum factor, because high commissions would have potentially wiped out any excess returns. In the U.S. stock market the race to zero commissions arrived at zero last year. That is great news for the individual investor that likes to buy and sell individual U.S stocks based on the momentum strategy. Spreads are now very tight in the U.S. stock market as well thanks to the rise of the high frequency traders (HFT). Thanks to Mr. Cifu of Virtu Financial and others, individual investors in the U.S. stock market can now have lower trading costs than their professional big whale competitors.

Holland Park Capital London Ltd has developed a proprietary quant screen that uses momentum to invest in stocks. On the 1st of July 2020 Q3 started and with $50000 a Trading Portfolio; Momentum strategy went live trying to beat the S&P 500 index with the momentum signal. Commissions are zero thanks to our U.S. broker and re-balancing will be quarterly. Below are some pictures from the momentum portfolio as of the second of July 2020;

The Trading Portfolio; Momentum has 226 small positions in S&P 500 stocks in Q3 2020. Quant strategies usually try to maximise the factor signal strength over as many stocks as possible in order to optimise the factor signal strength whilst at the same time reducing the risk of individual companies by diversification. So the Trading Portfolio; Momentum strategy will also try to show it is possible to make excess returns over the benchmark (S&P 500 index) without a concentrated portfolio of only say 20 names.

As an invest-able benchmark the Vanguard S&P 500 ETF (VOO) has been chosen. VOO can be expected to have a tiny under-performance versus the S&P 500 index, but at least is a real invest-able option for private investors. $50000 was invested on paper on the close of June 30 in the VOO. That paper trade has been put in two portfolio tracking websites. As of the second of July 2020 on the Stockrover website the VOO paper portfolio looked like below;

At the close of the 2nd of July 2020 the VOO paper portfolio on Stockrover had a value of $50596 so above the Trading Portfolio; Momentum of $50441. Let’s see if the real money Trading Portfolio; Momentum can make up that difference and outperform the VOO paper portfolio by 3% or so in Q3. Dividends for the Trading Portfolio; Momentum will be taken out and not be re-invested. Nevertheless Holland Park Capital London hopes the Trading Portfolio; Momentum can outperform the S&P 500 index even with re-invested dividends. Clearly one quarter out-performance or under-performance does not mean too much. Hopefully the Trading Portfolio; Momentum will outperform on 1 year, 3 years and 5 years time horizons and longer time horizons.

The VOO paper portfolio is also tracked on the Sigfig website. At the close of the second July 2020 the Sigfig looked like below.

As you can see the 2nd of July value for the VOO paper portfolio on Sigfig is even slightly higher at $50765. So the comparison will be by definition fair at the end of Q3 between the paper and real money portfolios as the VOO paper portfolio is ahead for now.

One of the regions active managers have most trouble outperforming their benchmarks is in North America. People say the market in the U.S. is very “efficient”; whatever that means. The SPIVA end of 2019 scorecard states 89% of the U.S. large cap funds under-performed the S&P 500 over the last decade. Let’s see if the Holland Park Capital London Ltd Trading Portfolio; Momentum can do better than that and outperform the S&P 500 in the U.S. over the next decade.

As can be found on the CNBC website Warren Buffett said in 2020 he believes average investors should buy the broad market for a long period of time instead of stock-picking advice of others.

“In my view, for most people, the best thing to do is owning the S&P 500 index fund,” Buffett said.

Hopefully the Trading Portfolio; Momentum will outperform Warren Buffett’s recommendation. An easy way in the U.S. to play the momentum factor would be a momentum ETF. Vanguard for example has the Vanguard U.S. Momentum Factor ETF (VFMO) and iShares has the iShares Edge MSCI USA Momentum Factor ETF (MTUM). It is nice to know the momentum factor can be accessed by private investors easily in the ETF space for reasonable fees.

Sometimes momentum works and sometimes it simply doesn’t. There will be three types of situations where momentum doesn’t work.

Normal situations where other factors like value for example will outperform the momentum factor a little. That can happen and is not a disaster long term. Long term the momentum factor should come out ahead as people are fashionable creatures.

The second situation where momentum doesn’t work is the already mentioned violent crowded momentum quant sell offs. If an investor doesn’t work with borrowed money and stop losses and can hang in there long term the second situation is not pleasant, but it can be made up for in the long run when momentum does work.

The third situation where momentum doesn’t work is more problematic. The third situation is when the economy comes out of a recession and there is a toxic waste rally. At the moment the U.S. is officially in a recession according to the National Bureau of Economic Research. The bureau’s Business Cycle Dating Committee said the expansion peaked in February 2020 and there has been a U.S. recession since. Now when the U.S. economy comes out of this recession the Trading Portfolio; Momentum can be expected to under-perform majorly. What typically happens is that the momentum screen selects overcrowded defensive and popular names that are not at risk of bankruptcy during a recession. Some of the names that are perceived as at risk of bankruptcy will decline 99% in a recession and may for example start trading from $50 all the way down to $0.10.

When the stock market smells the economy has stopped the bleeding and comes out of a recession the bankruptcy risk stocks as a group will start rising very fast. $0.10 becomes $0.20, shorts start to cover, $0.20 becomes $0.40, $0.40 becomes $0.80 and active managers start buying back their under-weights and selling their defensive's, $0.80 becomes $1.60, $1.60 become $3.20 and the newspapers say the economy is out of a recession and private investors start buying as well and $3.20 becomes $6.40 etc. Well everybody gets the picture. In such a toxic waste rally bankruptcy candidates can go up more than 100% multiple times and not owning those names during the quarter can really kill the relative performance of momentum versus the index for one year or more. In that sense the S&P 500 may well be the better investment until the National Bureau of Economic Research confirms the U.S. is out of the 2020 recession.....

Then again the saying is; put your money where your mouth is. Holland Park Capital London has just committed its money to the Trading Portfolio; Momentum strategy. Here is for hoping long term the Trading Portfolio; Momentum strategy is indeed going to beat the S&P 500 index and the VOO paper portfolio....

Hopefully you liked the blog. The blog is not advice on what you should do with your money and was written for information purposes only. When you invest in the stock markets it is possible to lose money. Please do your own research. If in any doubt what is best in your individual situation, please hire a licensed financial advisor. Good luck on your investment journey.