Relative momentum

What Is Relative Momentum?

Relative momentum is an investment strategy within portfolio theory that compares the performance of various securities or asset classes against each other to identify those that have recently outperformed. The core idea behind relative momentum is that assets showing stronger past performance relative to their peers tend to continue their outperformance in the near future. This approach often involves ranking a universe of investments based on their recent returns and then allocating capital to the top-ranking assets. Relative momentum is a key component of many quantitative investment strategies and is closely associated with the broader concept of momentum investing.³²

History and Origin

The concept of momentum in financial markets has roots that stretch back to the 19th century, with observations by figures like Charles Dow, who noted that stock prices moved in discernible trends.³¹ However, the modern academic foundation for relative momentum, and momentum strategies in general, gained significant prominence with the work of Narasimhan Jegadeesh and Sheridan Titman. Their seminal 1993 study, "Returns to Buying Winners and Selling Losers: Implications for Stock Market Efficiency," provided empirical evidence that stocks with strong past performance over three to twelve months continued to outperform, while poor performers continued to lag.³⁰ This research challenged prevailing notions of market efficiency and brought the momentum phenomenon to the forefront of financial academia and practice. Subsequent studies have reaffirmed the robustness of momentum across various markets and asset classes, solidifying its place as a recognized factor in finance.²⁹

Key Takeaways

• Relative momentum compares the historical performance of different assets to select those that have recently outperformed.
• It is a cross-sectional approach, focusing on how assets perform against each other rather than their own historical trend in isolation.
• This strategy is predicated on the belief that recent winners will continue to be winners, and recent losers will continue to be losers.
• Investors use relative momentum to guide allocation decisions, aiming to capitalize on persistent trends in relative strength.
• A typical look-back period for calculating relative momentum is between three and twelve months.

Formula and Calculation

Relative momentum is not typically expressed by a single universal mathematical formula in the way that, for instance, a discounted cash flow model is. Instead, it involves a comparative calculation and ranking process. The fundamental calculation for determining an asset's momentum involves measuring its returns over a specified look-back period.

To calculate relative momentum for a group of assets, the following general steps are taken:

1. Define a Look-Back Period (N): Common periods range from 3 months to 12 months.
2. Calculate the Total Return for Each Asset: For each asset (e.g., stock, ETF, mutual fund) within the selected universe, calculate its total return over the chosen N-month period. This includes price changes and any distributions (like dividends).
3. Rank Assets: Sort the assets from highest to lowest based on their calculated total returns.
4. Select Top Performers: Identify the top 'X' percentage or 'Y' number of assets from the ranked list.

For example, if comparing two assets, A and B, over a 12-month period:

Return for Asset A = (\frac{\text{Current Price of A} - \text{Price of A 12 months ago}}{\text{Price of A 12 months ago}})
Return for Asset B = (\frac{\text{Current Price of B} - \text{Price of B 12 months ago}}{\text{Price of B 12 months ago}})

If Asset A's return is higher than Asset B's, Asset A demonstrates stronger relative momentum. This simple comparison forms the basis for more complex implementations across an entire investment universe.

Interpreting Relative Momentum

Interpreting relative momentum involves understanding its implications for portfolio positioning and future asset performance. A higher relative momentum score for an asset suggests it has significantly outperformed its peers over the look-back period, indicating a potential continuation of this trend. Conversely, an asset with low or negative relative momentum signals underperformance. Investors interpret these rankings to make decisions about allocating capital, typically favoring assets at the top of the relative momentum ranking and divesting from those at the bottom.²⁸

The interpretation is also contextual. For example, in a broadly declining market, assets with strong relative momentum might still be experiencing negative, but less severe, losses compared to their peers. In such a scenario, relative momentum would point to the "least bad" performers, not necessarily assets generating positive risk-adjusted returns. Therefore, relative momentum is often used as part of a broader portfolio construction strategy, sometimes combined with other indicators or absolute momentum filters to ensure investments are in positively trending assets overall.

Hypothetical Example

Consider an investor, Sarah, who wants to apply a relative momentum strategy to a universe of three hypothetical exchange-traded funds (ETFs): Equity ETF, Bond ETF, and Commodity ETF. Sarah decides to use a 6-month look-back period.

Step 1: Gather 6-Month Returns

• Equity ETF: +12%
• Bond ETF: +3%
• Commodity ETF: -5%

Step 2: Rank the ETFs by Return

1. Equity ETF: +12%
2. Bond ETF: +3%
3. Commodity ETF: -5%

Step 3: Make Investment Decision
Based on this ranking, the Equity ETF has the strongest relative momentum. Sarah might decide to allocate a larger portion of her investment portfolio to the Equity ETF, or perhaps sell holdings in the Commodity ETF to fund a purchase of the Equity ETF, anticipating its outperformance to continue. This simple illustration demonstrates how relative momentum guides a comparative selection process among available investments.

Practical Applications

Relative momentum is a widely used tool in various areas of finance, particularly within systematic and quantitative investment approaches. Its primary application lies in asset allocation and security selection.²⁷

• Tactical Asset Allocation: Investors and fund managers use relative momentum to dynamically shift capital between different asset classes (e.g., stocks, bonds, commodities, real estate) or geographic regions. If U.S. equities are showing stronger relative momentum than international equities, a strategy might overweight U.S. stocks.
• Equity Selection: Within a single asset class like equities, relative momentum helps identify individual stocks or industry sectors that are outperforming. A portfolio might be constructed by selecting the top 'N' stocks with the highest relative momentum within a broad market index.²⁶
• Factor Investing: Momentum is recognized as a persistent "factor" that explains differences in returns across securities. Asset managers, including major firms like BlackRock, offer funds designed to capture the momentum factor, often using relative momentum principles to select holdings.²⁴, ²⁵ This allows investors to gain exposure to this empirically observed driver of returns.
• Managed Futures (CTAs): Commodity Trading Advisors (CTAs) often employ systematic strategies that leverage both absolute and relative momentum across a wide range of global futures markets, including currencies, commodities, and fixed income.²³
• Risk Management: While primarily a return-seeking strategy, relative momentum can indirectly contribute to risk management by allowing investors to rotate out of underperforming areas of the market and into stronger ones, although it does not inherently protect against overall market downturns.

Limitations and Criticisms

While relative momentum has strong empirical support, it is not without its limitations and criticisms. Investors considering a relative momentum strategy should be aware of several potential drawbacks:

• High Turnover and Transaction Costs: Implementing a relative momentum strategy often requires frequent buying and selling of securities as rankings change. This can lead to significant transaction costs, such as commissions and bid-ask spreads, which can erode returns.²² High turnover can also result in less favorable tax consequences in taxable accounts.
• "Momentum Crashes": A significant criticism is the susceptibility of momentum strategies to "crashes," which are infrequent but severe periods of large and persistent negative returns.²¹ These typically occur during sharp market reversals, especially after long market downturns, when past losers experience strong gains and past winners (which the strategy might be shorting or avoiding) perform poorly.²⁰ This can lead to substantial drawdown and can be particularly painful for investors.¹⁹
• Lagging Indicator Nature: Like many technical analysis tools, relative momentum is based on historical price data, making it a lagging indicator.¹⁸ This means signals may not be generated until a trend is already well underway, and reversals can occur quickly, leading to "false signals" or delayed exits.¹⁷
• Sensitivity to Look-Back Period: The effectiveness of a relative momentum strategy can be sensitive to the chosen look-back period (e.g., 3-month, 6-month, 12-month returns). Different periods may perform better in different market environments, and selecting an optimal period ex-ante is challenging.
• Not a Guarantee: Despite historical evidence, past performance is not indicative of future results. There is no guarantee that assets with strong relative momentum will continue to outperform, and the strategy can experience periods of significant underperformance.¹⁶

Relative momentum vs. Absolute momentum

Relative momentum and absolute momentum are two distinct but often complementary approaches within the broader field of momentum investing. The primary difference lies in their comparison base.

Relative momentum (also known as cross-sectional momentum or relative strength) focuses on comparing the performance of one asset or group of assets against another within a defined universe.¹⁴, ¹⁵ The goal is to identify the best-performing assets among a selection of peers, regardless of whether the overall market trend is positive or negative. For example, if all assets are declining, relative momentum would still select the ones declining the least.¹³ This strategy aims to capture the comparative strength of different investment options.

In contrast, absolute momentum (also called time-series momentum or trend following) assesses an asset's own performance against a static benchmark, typically a risk-free rate or zero, or against its own historical average.¹¹, ¹² The objective is to determine if an asset's price trend is positive (in motion) or negative (losing momentum). An absolute momentum strategy would only invest in an asset if its own trend is positive, and typically move to a safer asset like cash or bonds if the trend turns negative, aiming to avoid significant losses during market downturns.⁹, ¹⁰

While relative momentum answers "which asset is strongest?", absolute momentum answers "is this asset (or the overall market) strong enough to invest in?". Some advanced strategies, known as dual momentum, combine both approaches, first using relative momentum to select top performers, and then applying an absolute momentum filter to ensure that only positively trending assets are held, thereby aiming to enhance diversification and improve Sharpe ratios.⁷, ⁸

FAQs

What is the main goal of relative momentum?

The main goal of relative momentum is to identify and invest in assets that have recently outperformed other assets, with the expectation that this comparative outperformance will continue. It's about finding the "winners" among a group of investments.⁶

How does relative momentum help in investment decisions?

Relative momentum helps in investment decisions by providing a systematic way to rank assets based on their recent market trends and comparative strength. This ranking can guide investors on where to allocate capital to potentially maximize returns by riding ongoing trends.⁵

Is relative momentum a form of technical analysis?

Yes, relative momentum is often considered a component of technical analysis, as it relies on historical price and return data to identify patterns and predict future price movements. It is closely related to indicators like relative strength.⁴

What are some common indicators used in relative momentum strategies?

While not a single indicator, relative momentum strategies commonly utilize metrics such as total return over a specified period (e.g., 6 or 12 months) to rank assets. Tools like the Relative Strength Index (RSI) or moving average comparisons can also be used to gauge comparative price strength among different securities.³

Can relative momentum be used for all types of investments?

Yes, the principles of relative momentum can be applied across various types of investments, including individual stocks, ETFs, mutual funds, and different asset classes like equities, bonds, and commodities, provided there is sufficient liquidity and historical data for comparison.¹, ²