Does Human Behavior Explain Momentum Investing’s Successful Record?

Investors are only human, but that could explain the reason why when it comes to factor investing, momentum is one with a strong record of success to substantiate its use. A working paper by Nanyang Technological University’s (Singapore) Jiang Luo, UCLA Anderson’s Avanidhar Subrahmanyam and University of Texas’ Sheridan Titman attempted to demystify momentum.

“Momentum investing’s strong record of success as a strategy has vexed academics and market professionals alike because it defies one of modern finance’s key tenets: that markets are efficient. In part, efficiency means that no trading pattern should persistently beat the market because as soon as investors learn it, stock prices should quickly adjust to remove the easy reward potential,” wrote Tom Petruno in the UCLA Anderson Review.

“Decades of research have sought to explain the momentum anomaly in the context of the efficient market theory,” Petruno added. “Now, in a working paper, Nanyang Technological University’s (Singapore) Jiang Luo, Subrahmanyam and University of Texas’ Sheridan Titman suggest that much of that research amounted to overthinking. Instead, they propose an explanation rooted in basic human nature. Many investors, they say, simply refuse to believe that their competition in the market might know more than they do. In the case of rising stocks, that skepticism acts as a brake, slowing their advance but also extending it.”

Riding the Wave of Momentum

Momentum—once it picks up, it can be difficult to stop and while the debate in the capital markets is whether value can sustain its lead over growth, investors can’t forget about the momentum factor, especially if events like a U.S.-China trade deal can spark a year-end rally.

One ETF that investors can look at when it comes to riding the wave of momentum is the iShares Edge MSCI USA Momentum Factor ETF (BATS: MTUM), which has been yielding gains of over 23% YTD according to Morningstar performance numbers. The fund seeks to track the investment results of the MSCI USA Momentum Index.

The fund generally will invest at least 90% of its assets in the component securities of the underlying index and may invest up to 10% of its assets in certain futures, options and swap contracts, cash and cash equivalents. As far as the index goes, it consists of stocks exhibiting relatively higher momentum characteristics than the traditional market capitalization-weighted parent index, the MSCI USA Index, which includes U.S. large- and mid-capitalization stocks.

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