“[Momentum is] the single largest inefficiency in the market. There are plenty of inefficiencies, probably hundreds. But the overwhelmingly biggest one is momentum.” — Jeremy Grantham
If, as many experts say, the markets are indeed efficient, and the movements of risky assets are random in nature, then the returns of these portfolios should reflect this randomness and this ranking mechanism should have no effect. What we observe, however, is a different story altogether.
Probability that top n ranked assets by 6 month momentum will perform in the top half the following month.
Source: Yahoo finance, Gestlatu.com
In reality the best performing portfolios by far were those with the highest momentum. Of course, any avid Efficient Market Hypothesis practitioner would question whether this type of simple, but actively managed strategy is capable of outperforming an even simpler buy-and-hold investment portfolio. The chart below compares the top two momentum portfolio against an equally held portfolio of all 10 asset classes rebalanced monthly.
Equity lines, top and bottom n by momentum, rebalanced monthly
Source: Yahoo finance, Gestlatu.com
Again we see here the vast difference in return and risk characteristics. The top two momentum portfolio grew at 21.13 percent a year vs buy-and-hold at 8.9 percent. On the risk side we see the largest peak-to-trough loss being -19.42 percent versus -43.90 percent respectively. All of this without forecasting or having to read a single analyst report, that is the power of momentum.
Market inefficiencies are often fleeting and difficult to exploit with any success over long periods of time. By its very nature the market tends to find anomalies and eliminate them in due course. Momentum, however, seems to fly in the face of this reality. This is because as long as markets are driven by behaviourally flawed participants that make decisions based on herding, this phenomenon will continue to persist and we will be able to exploit it.
With this final step, in combination with active diversification (link coming soon) and volatility management, we are able to offer one of the most stable and adaptive wealth management systems available to anyone today.
While uncertainty still reigns supreme in global financial markets, our Darwin Strategies provide an optimal solution for surviving the treacherous markets of the future. To learn more, contact us at www.darwinfunds.ca.