Momentum Strategy and How to Temper It

Momentum Strategy and How to Temper It

While the coronavirus  pandemic “rocked” global markets in the first quarter of 2020, a recent Morningstar article reports that momentum exchange-traded funds navigated fairly well, an unusual occurrence that cannot necessarily be counted on.

“Momentum strategies typically struggle when the market abruptly changes direction because the historical stock performance they use to predict future performance is no longer relevant to current market conditions,” the article explains. It adds, however, that the circumstances surrounding the coronavirus sell-off were an exception, as heavy allocations to defensive sectors like utilities, consumer staples and healthcare, which “provided some ballast as the market declined.”

But that doesn’t mean these strategies will always enjoy this kind of positioning, the article noted, outlining some risks to consider:

  • Volatility: This can occur when markets are flooded with new information and “investors can’t agree on what that information means for future stock performance.”
  • Changes in Market Direction: During inflection points, “leadership among stocks or market segments shifts and the past is no longer prologue.”
  • Relative performance of Value: When value strategies are working well, momentum tends to struggle.

According to the article, although there is no way to completely eliminate these risks, there are a few safeguards that can “soften the edges and create a more palatable momentum strategy:

  • Adjustments: By “adjusting each stock’s momentum for its historical risk”, managers can “shift their focus to stocks with more consistent price momentum, which have a better chance of maintaining their positive performance in the future.” The article cites one example—dividing each stock’s price momentum by its trailing three-year volatility.
  • Pairing with Value: The “most effective way to curb the risk of a momentum portfolio is to pair it with a complementary value fund, as they tend to work well at different times.”