Why Does Momentum Work?

An interesting article in the Economist which reports on the recent work that is being done on the efficacy of momentum investing.

Obviously, given the nature of the Fund King System, we are positively biased towards this type of report because it confirms much of our thinking on the matter.

More interesting than whether these market inefficiencies exist is the reasoning behind why a momentum based strategy might work.

One interesting aspect was the comparison of the development of long term trends in commodities and currencies with what is going on in the world of equities and fixed income. Perhaps the bundling and commoditization of equities and fixed income products has led to those asset classes taking on more of the aspects of commodities.

How did this happen? In an effort to nail down the sources of returns (explored in the article), the financial industry has created methods and products that allow professional investors to only participate in certain aspects of securities. That requires deep inventories of raw material (stocks, bonds, mortgages, car loans…) and trading desks to hedge the risk back and forth. Since institutions account for 60-80% of trading in most of the financial markets we have observed, their actions can drive the prices of the underlying assets well above or below a theoretical “fair value” because the traders are not as concerned with the over- or under-valuation of a particular asset as long as they are able to achieve their trading and product goals.

The article is part of the Economist’s free offering at this link.

Read more at Fund-King.com