Historically, momentum investing has worked best when asset returns show low correlation. When prices have moved up and down together, the momentum factor has not shown outperformance.1
Momentum stocks are more risky
Investors embracing momentum stocks should expect higher volatility. Because momentum stocks tend to see stronger expected earnings growth than the average stock, volatility for momentum stocks should be relatively higher than broad market averages. Big movements in earnings open up the chance for both positive and negative surprises. Potentially, there is more that can go right or wrong for a company with rapidly growing earnings than a company that has a more stable earnings profile. To illustrate this point, since its inception in March 2007, PDP has had a beta of 1.07 to the S&P 500 Index. Its volatility is also higher at 19.26% compared to 16.53% for the S&P 500 Index (based on standard deviation of index returns).2
Concluding thoughts
It is important to note that momentum investing is sophisticated and complex, so investors should always discuss with a financial advisor before deciding when to use momentum investing. After consultation with an advisor, investors may want to explore using the momentum factor as a way to gain exposure to growth potential. Companies experiencing strong upward price momentum could be experiencing strong earnings growth. However, investors should realize that momentum investing has worked best when the market is discriminating between good and bad stocks, and remember that momentum stocks usually carry greater risk.
The prerequisite for momentum investing rests in the ability of the investor to gather price history so an asset’s price strength can be measured. ETFs can provide an investor access to momentum investing across asset classes and make implementation of a momentum based strategy easy to execute. Those who would like to know more about momentum investing can explore the PowerShares DWA Momentum-based ETF solutions:
1. Source: Ned Davis, Fama/French Library, Invesco PowerShares. Based on an examination of the average monthly return of momentum factor stocks by quintile of stock market correlation (median correlation of S&P 500 stocks to the S&P 500 Index.)
2. Source: Bloomberg LP as of Oct. 28, 2014