Do shares exhibit a momentum effect from one month to the next?
If we selected the 10 best performing FTSE 100 shares in one month and created an equally-weighted portfolio of those shares to hold for the following month, would that portfolio out-perform the market index?
Or, more interestingly, if we did this systematically for a year (i.e. our portfolio each month is comprised of the 10 best performing shares in the previous month), would that portfolio out-perform the FTSE 100 Index?
The chart below shows the result of operating such a momentum portfolio in 2011. Each bar represents the out-performance of the portfolio over the FTSE 100 Index. For example, in February the 10-share portfolio would have increased 6.2% against a FTSE 100 increase of 2.2%, giving an out-performance of 4.0.
Over the year, the portfolio would have out-performed the index by an average 1.1 percentage points each month. At the end of the year the portfolio would have increased 10.3% on its starting value, while the FTSE 100 index fell 3.1% over the same period.
The chart below illustrates the result of operating such a portfolio in 2010.
This time the average monthly out-performance of the portfolio over the FTSE 100 Index would have been 0.9%.
Note: An academic paper published in 2001 looked at momentum trading strategies in the UK stock market. Although it identified several profitable strategies it found that momentum effects were not consistent and therefore the returns on the strategies were dependent on the period over which the strategies were applied.