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opinion

A long bus ride home got me thinking about momentum, or the lack thereof.

When it comes to stocks, momentum is the propensity for trends to continue. Stocks with big gains in recent months are expected to continue to climb in the short term. Similarly, the laggards – much like a certain bus – usually continue to lag.

Momentum shines when it comes to returns. It has outperformed over the very long term in nearly all major markets, across many asset classes and using a variety of different approaches.

For instance, professor Kenneth French of Dartmouth College in New Hampshire maintains a database that includes studies of momentum and size. In one study, he tracked a portfolio formed by taking the 10 per cent of U.S. stocks with the highest returns over the prior year, not including the prior month.

The portfolio was reformed each month, stocks weighted by size and returns here are provided in U.S. dollar terms.

The U.S. momentum portfolio gained an average of 16.3 per cent annually from the start of 1927 through to the end of September, 2022. By way of comparison, a market portfolio containing the largest 30 per cent of U.S. stocks (similar to the S&P 500 index) gained an average of 9.7 per cent annually over the same period.

Turning to the Canadian stock market, I wanted to see how a blended approach to momentum fared in the recent times. The idea is to pick stocks with the best combination of three-, six- and 12-month prior returns while including a few risk-reduction features along the way.

Before focusing on momentum, I start with the largest 300 common stocks on the Toronto Stock Exchange. (The current list has stocks with market capitalizations in excess of roughly $550-million.) Doing so avoids smaller stocks that can sometimes be difficult to invest in. Similarly, I exclude stocks without a year’s worth of return history and those that fell below $2 a share over the prior 52 weeks.

I take another risk-reduction step by cutting out the 20 per cent of stocks with the highest volatilities over the prior 260 days. The idea is to try to avoid extreme situations. Tests suggest doing so provides a small return boost and a modest reduction in volatility for the resulting portfolio.

Momentum is then used to pick the 10 per cent of the remaining stocks with the highest prior three-, six- and 12-month returns for inclusion in the Blended Momentum portfolio, which holds an equal dollar amount of each stock.

The whole process is repeated each month and the portfolio’s return history is shown in the accompanying chart, along with the gains of the S&P/TSX Composite Index, which represents a reasonable proxy for the Canadian stock market.

The Blended Momentum portfolio gained an average of 16.6 per cent annually from the start of 2000 through to the end of October, 2022. By way of comparison, the S&P/TSX Composite gained an average of 6.5 per cent annually over the same period. (The Canadian returns are based on data from Bloomberg. All of the returns herein include dividend reinvestment but do not include inflation, taxes or trading frictions.)

The Blended Momentum’s gains are grand even though it started just before the market downturn in the summer of 2000. You can examine the portfolio’s down periods in the second chart, which highlights how far it fell as a fraction of its prior peak.

The portfolio dropped suddenly in early 2000, but held up pretty well compared to the market index, thanks largely to the exclusion of stocks with sky-high prior volatilities. Alas, more generally, momentum portfolios tend to suffer from sudden and severe crashes.

Another downside is that momentum investing requires a great deal of effort to implement in practice because of the frequent and extensive rebalancing needed. Careful and cost-efficient trading is also a must, while taxes are an important consideration.

In general, opting for longer holding periods tends to reduce the momentum advantage quickly and annual rebalancing is usually suboptimal.

The Blended Momentum portfolio gained an average of 14.4 per cent annually when rebalanced annually from the start of 2000 to the start of 2022, while the S&P/TSX Composite climbed by an average of 7 per cent annually.

But the return reduction would have been much more significant without the volatility cap.

With a little luck, momentum will continue to generate profits for a long time and help active investors get off the slow bus.

Norman Rothery, PhD, CFA, is the founder of StingyInvestor.com.