Should you invest in overlapping momentum investing strategies?

Today we will talk more about quantitative investing strategies – our focus is on momentum investing. So, let’s imagine we already have a set of profitable investment strategies, and we need to combine them. Our goal is to use strategic allocation to get the best risk-adjusted return that is possible for our individual investment strategies and combined together for our investment portfolio. Naturally, there is no correct answer here. We will look at a few ways to understand what happens when we combine different quantitative investing strategies. The question we will look at in depth is whether we can combine similar yet different investing strategies.

Now, momentum investing works pretty well in bullish markets. And has become widely adopted by many investors, FIIs, quant funds, mutual funds & others – all of whom use momentum as part of their core strategy for building their investment portfolio. However, a crucial question that we get asked is whether investing in overlapping momentum strategies yield higher returns for investors? Can you actually build a portfolio with multiple momentum investing strategies that overlap one another? And can this actually work to get better risk adjusted returns?

What is the efficient market hypothesis? 

Well it is a well known theoretical finance concept (some may argue it has real world implications too), which says that stock prices reflect all available information. What does this mean? It means it should be impossible for anyone to consistently achieve returns that exceed the average market returns on a risk-adjusted basis. And as we can see in Wright Momentum, and other momentum strategies – all of these capitalize on the continuation of existing market trends, which challenges the efficient market hypothesis.

Now, momentum investing works pretty well in bullish markets. And has become widely adopted by many investors, FIIs, quant funds, mutual funds & others – all of whom use momentum as part of their core strategy for building their investment portfolio. However, a crucial question that we get asked is whether investing in overlapping momentum strategies yield higher returns for investors? Can you actually build a portfolio with multiple momentum investing strategies that overlap one another? And can this actually work to get better risk adjusted returns?

Momentum Investing and Investor Heterogeneity

Investors, limited by their ability to process information, often rely on past data and historical returns to predict future performance. With the advent of AI, machine learning models – few quant funds such as Wright Research are building towards predicting and forecasting how stock markets will move over the next 1 day, 1 week and 1 month. But for a large majority of investors historical return analysis is the starting point of their analysis.

What does this mean?

Real-world investors, contrary to the theoretical investors that form part of economic models, have inherent limitations. We are limited by the amount of information we can process, how to predict future valuations & much more. This investor heterogeneity means that different investors may interpret the same market data differently, leading to a variety of momentum-based strategies in the market. They may even look at a different time period or time horizon to lookback on to assess a stock or a market’s performance.

Why is it important to understand this?

The key to understanding the potential of overlapping momentum strategies lies in this investor heterogeneity. The differing time horizons employed by momentum investors can lead to distinct outcomes in terms of portfolio performance. For example, an investor focusing on a six-month lookback period might identify different ‘winning’ stocks than one looking at a twelve-month period. This diversity can affect the overall profitability of momentum strategies.

And when there are all these investors taking decisions based on their own analysis and investing in their own momentum strategies this could impact how stock markets move. Significant market players like mutual funds or foreign investors, hedge funds, quant funds, and even a combination of individual investors etc could have some implications that could influence stock price movements. This could potentially lead to market scenarios where trends are both created and amplified by the actions of momentum investors.

Overlapping between Wright Momentum & Alpha Prime and how to choose a suitable smallcase?

The fundamental difference between Wright Momentum and Alpha Prime is that Alpha Prime is a 10 stock only portfolio – it is highly concentrated, highly aggressive and a very high risk portfolio.

Wright Momentum on the other hand is a more diversified portfolio as it contains 20-25 stocks which mean it is less aggressive albeit still a high risk portfolio. Both portfolios follow the momentum strategy but also look at different momentum attributes.

Alpha prime currently is more focused on smallcap stocks as they have rallied well so far, however this may change in the future depending on how markets perform and what is doing well at the time. The decision of which is best, depends on your risk profile, tolerance level and preference. As we stated earlier, Alpha Prime is highly risky and if you are not comfortable with sharp price movements when the market corrects, then this may not be the right portfolio for you.

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