Market Beat: The momentum style of investing
There are different styles of investing. Growth and value are two of the main styles. Value investors seek out stocks that are trading at low valuations using metrics like the PE, or price to earnings ratio, and the PB, or price to book value.
Growth-oriented investors look for stocks that may be relatively expensive but are expected to have strong earnings growth.
Momentum is a type of growth investing and the concept is relatively simple. A good example is the S&P 500 Momentum Index. The S&P 500 Momentum Index is made up of the top performing stocks from the 500 stocks that make up the S&P 500 Index. The methodology is basically that they select the top 100 stocks from the S&P 500 based on their trailing twelve months performance and some other factors. The portfolio is re-balanced twice per year. So, every six months they identify the top stocks and if there have been any changes, they sell the ones that are underperforming and buy the new leaders.
The S&P 500 Momentum Index has had good performance relative to the S&P 500. Over the last 10 years the Momentum Index has averaged a total return of 14.74%, while the S&P 500 has averaged 13.45%. Over a five-year period, the Momentum Index has gained an average of 12.20%, while the S&P 500 has risen by 10.11% per year. For three years the Momentum Index has outperformed by gaining 15.93% compared to 12.70% for the S&P 500. However, over the last year the Momentum Index has slightly underperformed with a return of 2.67% compared to 2.92% for the broad S&P 500 Index.
The momentum style doesn’t have to be used just for individual stocks, either. By using ETFs, you can apply the same techniques to a sector or a country rotation strategy. With sector rotation you focus on the top performing sectors of the economy and rotate on a regular basis as is done with the S&P 500 Momentum Index. With a country strategy, you can allocate a portion of your foreign stocks in a similar fashion by rotating amongst the top performing countries in the world.
There has been some serious academic research done on the different investing styles and one conclusion is that combining value with momentum can produce good results. If you invest in broad based index funds, you will have exposure to the leading stocks as well.
Kenneth Roberts is a Truckee-based Registered Investment Advisor. Information is at his blog at http://www.sellacalloption.com or 775-657-8065. The mention of securities should not be considered an offer to sell or solicitation to buy investments mentioned. Consult your investment professional to understand the risks and/or how the purchase or sale of these investments may be implemented to meet your investment goals. Past performance is no guarantee of future results.