Here Are Some Tips for Beating the High-momentum Stock Market

Over the past year, stocks with strong recent performance have once again failed to keep up with the broader market. Historically, momentum stocks—those with the highest returns over the prior year—have significantly outperformed the overall market. However, in recent years, these stocks have struggled to match the gains of the S&P 500.

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This trend is evident in the performance of the iShares MSCI USA Momentum Factor ETF (MTUM), the most widely held exchange-traded fund tracking momentum stocks. Over the past 12 months, MTUM has lagged behind the S&P 500’s total return, posting a 10.1% return compared to the index’s 10.9%. This underperformance is not a short-term anomaly—over the past three, five, and ten years, the fund has consistently trailed the broader market.

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Market analysts have put forth various theories to explain the recent decline in momentum investing’s profitability. However, a deeper cause may be at play—one that has largely gone unnoticed on Wall Street. A 2022 study published in the Review of Financial Studies suggests that a key factor in momentum’s diminished returns is a structural change in how Morningstar calculates its mutual fund ratings.

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The study, titled Ratings-Driven Demand and Systematic Price Fluctuations, was conducted by finance researchers from Ohio State University, the University of Utah, the University of Arizona, and the University of Washington. Their findings indicate that a change Morningstar implemented in 2002 fundamentally altered how investor capital flowed into high-performing funds, indirectly weakening the momentum effect.

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Before 2002, Morningstar assigned its highest rating of five stars to funds that ranked at the top of the overall performance charts. Since these top-rated funds frequently held many of the same high-performing stocks, new investor money would pour into these funds, further driving up the prices of those stocks. In effect, Morningstar’s old rating system helped fuel momentum strategies by reinforcing price trends.

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However, in 2002, Morningstar changed how it assessed funds. Rather than ranking them solely based on overall market performance, the firm began evaluating funds within their respective investment categories—such as large-cap growth, small-cap value, or international equities. Under this new system, a fund could earn a five-star rating even if it delivered lower absolute returns, as long as it outperformed its specific category.

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This meant that high-performing funds in a struggling category, like small-cap value during a downturn, could still receive top ratings despite generating weaker overall returns than funds in thriving categories.

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This change had a significant unintended consequence: investor capital was no longer concentrated in the same high-flying stocks that previously benefited from momentum investing. Instead, cash flowed into a wider array of funds spanning different investment styles, reducing the amount of money chasing the highest-returning stocks. As a result, momentum strategies lost a key source of their past success.

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The effects of this shift are illustrated by a long-term analysis of momentum stock performance. The study’s data, which includes research from Dartmouth professor Ken French, shows how a portfolio of the top 10% of stocks based on trailing 12-month returns performed relative to the broader stock market over the past two decades. The findings reveal a noticeable decline in momentum’s effectiveness, coinciding with Morningstar’s rating methodology change.

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Historically, momentum stocks have been about 10% more volatile than the overall market. However, the additional risk was often justified by superior returns. Investors who were willing to accept this higher volatility typically earned greater long-term profits than those who followed a standard momentum strategy.

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Interestingly, the study suggests that a similar return profile—without the added risk of stock selection—could be achieved by investing in a broad market index fund on 10% margin.

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This insight challenges the traditional appeal of momentum investing. If investors can obtain comparable or superior returns simply by leveraging an index fund, the case for actively pursuing momentum strategies weakens further.

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With momentum stocks underperforming over multiple timeframes, investors may question whether this strategy will regain its past dominance. Some analysts argue that market conditions could shift in favor of momentum investing if certain structural factors change. Others believe that the diminishing effectiveness of momentum may be a lasting consequence of altered investor behavior and capital flows.

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While short-term trends can be unpredictable, the data suggests that momentum investing no longer holds the same consistent advantage it once did. Investors who historically relied on momentum strategies may need to reassess their approach, particularly in light of changes in how capital is allocated within the market.

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Ultimately, the decline in momentum’s effectiveness underscores a broader lesson for investors: market dynamics are constantly evolving. Strategies that worked well in the past may not always deliver the same results in the future. By understanding the factors influencing investment trends—such as shifts in fund ratings and investor capital flows—market participants can make more informed decisions about where to allocate their money.

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