Pitfalls of Momentum – January 2021 Newsletter

When I was younger and more naive than what I am today, I used to argue strongly for Technical Analysis vs Fundamental Analysis. In a way, I thought of myself as a crusader for an art that few seemed to understand much let alone use it.

Today, anyone and everyone has access to a freechart with drawing tools making them experts in patterns and indicators. With a 50% probability of being right (it being binary) and hundreds of charts, it’s easy to look like an expert.

One question that troubled me the whole time though was why if Technical Analysis was so good was not used by any major fund managers. What was inhibiting them from using Technical Analysis when it seemed like it was a great way to not just hedge the risks but pick the winning stocks. 

Today, the same questions can be asked about Momentum Investing. For all our claims, there is just one PMS which has a pure price based momentum portfolio. Why is that so? If as some advisors claim, Momentum Investing is the greatest innovation in finance, why aren’t they managing money?

While we do have CTA’s that do use some sort of Technical Analysis, the returns in the last decade and more have been unsatisfactory to say the least. In case of Momentum, we do have Hedge Funds and ETF’s trading the same in the United States but the AUM is measly in comparison to the mainstream ETF’s 

Here is a performance comparison of iShares MSCI USA Momentum Factor ETF vs S&P 500

India is yet to see anything close to that. One reason I believe is a major inhibitor – liquidity. Momentum or Price chasing works on the concept of buying what is going up and selling what is going down. 

But if you are managing a 1000 Crore fund with a 20 stock portfolio (5% equally weighted) and don’t want to move the market, how many stocks shall qualify (assuming that you can buy / sell upto 10% of the volume traded in a day?

Using a 12 day average volume (not delivery which is even lower), we can get only 32 to 35 stocks where you can buy or sell 50 Crores worth of securities without exceeding 10% of total volumes. If you are willing to go upto 20%, the number of stocks available move to around the 75 mark, better but way lower.

Most fundamental portfolios have a long holding period (even though they may churn a small bit of the portfolio much more frequently). Even with a monthly reshuffle, my own holding period falls to just around 4 months. Dip to Weekly and you shall end up churning the portfolio every second month. 

In advisory, since it’s up to the client to execute, all these headaches vanish instantly. Momentum Investing in many ways is similar to Micro Cap Investing. There is a reason for no Micro Cap funds out there too – again it’s a question of Liquidity.

Today, there are close to 22 advisors on smallcase alone who have a Momentum Portfolio. Since many have more than one portfolio, we are talking of nearly 75 to 100 portfolios. I have no subscription to any of them but my guess is that the stock overlap would be close to 80% across the board.

Having started my stock market journey on a regional stock exchange and one thing we feared the most – market orders. With low liquidity, we had no way to know how far away we would get filled. I don’t remember punching in a market order once, it was always limit orders at the best Ask or Bid price. New age rodeo’s on the other hand fancy market orders. While market depth has definitely improved quite a bit, the hard reality is that when thousands of orders are punched at market, there is a risk of the cart moving the horse than vice versa.

“Not everything that counts can be counted, and not everything that can be counted counts.” goes a popular saying wrongly credited to Albert Einstein. While we can count the impact of Brokerage and Taxes, what is missed out is the Slippage. 

While slippage is low when we send an order for a few thousands of rupees, the impact of slippage when the amount becomes bigger becomes very noticeable. Big funds hence spend a lot of time and energy to try and reduce such impact to a level that is more comfortable. 

Compared to other factor based strategies, Slippage is something that can have a large impact in Momentum based strategies versus Value or Quality where the churn factor is very low. A value fund can take months building up a position while a Momentum fund would have already entered and exited a stock in a month or less.

Momentum strategy like any other strategy is bound to go through its bad times. My own equity curve hit a high in January 2018 and that high was surpassed only in late 2020. The worst thing though was that this happened even as the markets continued to hit new highs.

This is tough compared to say a Mutual Fund or a PMS since you are required to continue to monitor / action every month or week. If you are not mentally prepared for such eventuality, you will find yourself exiting the strategy at the worst possible time. 

Momentum in recent months has seen a huge upswing, but then again, what hasn’t really. This seems to have made it seem like a riskless way to make money. This has been further encouraged by advisors who are experienced enough to know that risk in do-it-yourself is multiple times higher than with even an average mutual fund. 

As I was writing this, the wonderful Bob Seawright’s newsletter landed up and one quote that stood up 

“There’s plenty of people who sell bad stuff knowingly, but I think the far bigger problem is inappropriate sales that are well-intended. I’ve seen people who sell bad stuff to their moms, because they thought it was the right thing.”

Bob Seawright

Momentum or Value or Growth – everything can be mis sold. It’s finally your money on the line and if you don’t care enough, no one else will either. If you are not prepared to be invested for a long period of time, no strategy or investment will ever suit you.