While our research has shown that over time momentum has the ability to generate outperformance, it certainly will not outperform all the time. In general, we can point to certain factors that will lead to markets being favorable or unfavorable for Relative Strength.
Clear Leadership, Sustained Trends
Favorable Relative Strength environments have stable leadership, which means the leaders identified by Relative Strength remain strong for extended periods. They also tend to have a wider gap between the leaders and laggards in a market. For example, 2020 was a strong year for Relative Strength, and when you think about it, this makes sense. The work from home, ecommerce, and other companies we saw lead the way during 2020 established themselves as clear leaders and remained that way for an extended period. At the same time, there we clear losers that remained losers for an extended period in certain spaces like travel and energy, in particular.
Weak Relative Strength environments, by contrast, will tend to be choppier, with no clear leadership or major changes in leadership, which does not allow a Relative Strength strategy to latch onto and ride a clear trend.
In general, we want to see strong follow through from our Relative Strength leaders. In those choppier markets with more frequent leadership changes we are left constantly adjusting to new information and can end up chasing our tail for a bit.
As a result, you might notice that Relative Strength strategies tend to have more turnover when they are underperforming. This is a sort of self-correcting mechanism where they will attempt to find what is working. On the other hand, when Relative Strength strategies are performing well, they tend to have less turnover, as this means they have latched on to a strong trend that is continuing.
Return Dispersion
While we have shown momentum can be effective across and within different universes, there are universes that momentum is generally better-suited for due to the characteristics of the underlying constituents of the universe. In markets where there generally a large difference between the best performers and worst performers in a given year, Relative Strength will generally have an easier time identifying the leaders and will likely perform better over time.
Momentum is a factor that works best when there is a large dispersion in the returns of the constituents in the universe. In a universe of 10 broad economic macro sectors, the range in returns from best performer to worst performer will almost always be smaller than the range in returns of the sub industry groups. A momentum model based on a more targeted universe allows you to focus on smaller, more specific segments of each macro sector.
For example, purchasing a broad macro sector ETF for healthcare gives you exposure to every single industry group. But it is entirely possible that drugs and biotechnology, for example, are the only groups that have superior momentum characteristics at a given time. A more granular approach allows you to purchase only the groups that have the best Relative Strength characteristics and exclude groups like hospitals, medical supplies, etc. when they are underperforming.
Of course, getting more granular to increase returns also has the potential to increase your portfolio’s volatility. A portfolio of more granular exposure is more concentrated in securities with characteristics of a specific factor (in this case, momentum), and will be more subject to the ups and downs of the momentum cycle. A portfolio of broader exposures contains a lot of securities that don’t have superior momentum characteristics, which helps smooth out the volatility over time.
Can You Time Relative Strength?
There may be ways to alleviate some of the performance lag experienced by trend-following Relative Strength strategies whenever there are changes in leadership, but models that can identify these environments and shift to account for those changes are very difficult to implement. While it can be very uncomfortable for investors, we have found that patience and adhering to a consistent strategy are the best ways to deal with periods of underperformance. You may also find that rather than attempting to time your strategy to know exactly when to focus on momentum and when to focus on other factors, you might be better off pairing your momentum strategy with strategies based on factors that can be additive to momentum . This can allow you to reduce your portfolio’s exposure to the momentum factor while still benefiting from its ability to produce long-term outperformance.