Momentum investing works, and it works best in an opportunity-rich environment. You just need to know where to look.
A just-published report in Reuters Hedgeworld, which I happened to have authored, demonstrates the power of using heat maps that incorporate sector, style, and country to generate alpha. The report provides heat maps for investors that have proven effective.
The standard disclaimer, “past performance is not an indicator of future results” might not be true, if momentum investing works. Studies have shown that investing in yesterday’s winners can indeed generate alpha over time. Investor behavior is the probable cause of momentum, believing we can buy past performance.
Heat maps are good visuals for finding yesterday’s winners and losers. A heat map shows shades of green for “good,” which in this case is good performance, and shades of red for “bad,” indicating underperformance. Yellow is neutral. The idea is to focus on the dark greens and dark reds for clues on momentum and reversals. The opposite approach to momentum is “regression to the mean,” which seeks reversals – winners switch to losers and vice versa.
Presented below are charts showing back-tested performance results using a very simple rule. “High” takes the three winners in the previous 12 months and invests equally in them for the next quarter. “Low” takes the three worst performers. Results are for the 9.25 years ending March 31, 2013.