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Over at the Economist, Buttonwood highlights a study that touches on one of our favorite subjects—momentum investing. The study shows that momentum has been a big winner.

Over the period 1980-2009, AQR's momentum index returned 13.7% a year against 11.2% for the Russell 1000 index. The volatility of the momentum index was rather higher but the Sharpe Ratio (excess return divided by volatility) was still better than the Russell index. In the smallcap section, the return was 15.4% a year. Again the volatility was high but the Sharpe ratio was significantly better than that of the Russell 2000.

Analysis shows that stocks with the big mo (as the first President Bush called it) are more correlated with growth than value. Potentially this makes the approach a good diversifier for value investors who, as is well known, suffer from some terrible periods of underperformance. Adding a 50% momentum weight to a value portfolio would have increased both returns and volatility by a percentage point over the last 29 years, a decent trade-off.

The problem, of course, is that this has already happened. Some analysts, like David Merkel, think that the momentum is getting crowded—and I suspect he’s right.

I think the fascinating part is the fact that the stock market is self-aware. That's a crucial point -- it's not a blank slate. The market knows where stocks have been and past prices do have an impact on future prices.

Posted by edelfenbein at July 24, 2009 10:19 AM