Last Updated on 24 November, 2021 by Samuelsson

There are different theories out there, including the Capital Asset Pricing Model (CAPM), the Arbitrage Pricing Theory, and the Fama-French Three-Factor Model, which try to explain investors behavior in the market, but researchers have found that investors do not follow these theories, but instead, act in accordance with the psychology market.

This has led to the observation of certain anomalies in the market, including the momentum factor. The momentum effect is one of the most popular, strongest, and well-researched anomalies in the financial markets. In this post, we will explore research findings on the momentum factor effects in equity indexes, but first, we will explain what momentum factor means and some general facts about equity indexes.

What does the momentum factor mean?

In the financial world, momentum generally refers to the rate of change of a security’s price in one direction — that is, it is used to explain the capacity of a price trend to sustain itself and continue in its current direction, either rising or falling for a particular length of time.

In essence, momentum trading is a trend-following strategy that seeks to enter a trade when the trend is picking up steam. The strategy aims to buy assets that have performed well in the past and sell the ones that have performed poorly.

The momentum factor was originally observed in stocks, but since then, it has received a lot of interest from academics who have studied it in other asset classes, including country equity indexes. And now, numerous research has shown that the momentum factor effect exists in country equity indexes. But before we delve into the research findings, let’s explore general facts about equity indexes.

General note about country equity indexes and the momentum factor

An equity index is a market derivative that measures the price performance of a basket of stocks using a standardized metric, such as market-cap-weighting or price-weighting. A country equity index is a broad equity index that is used to gauge a country’s equity market. It could be a composite index or a broad market index, like the S&P 500 Index, which is a market-weighted index.

Equity indexes are mere market indicators and are not directly tradable but can be traded indirectly via exchange-traded funds (ETFs) — also known as index ETFs — that track those equity indexes. The availability of those index ETFs that track various countries’ equity market indexes provides an attractive vehicle for investors who want to invest in low-cost, geographically diversified assets. Interestingly, the historical total return data for these country indexes are available from their database in both local currencies and US dollars.

Apart from the individual country equity indexes, there are also equity indexes created from various country equity indexes. An example is the MSCI World Index, which consists of 70 country indexes, weighted on a market-capitalization basis. There are ETFs that track this index. Those ETFs make it possible to easily ascertain the returns of the index. Without those ETFs, one can only estimate the benchmark of the world equity index by investing in a well-diversified, market-cap-weighted portfolio of various country indexes.

Academics like to investigate momentum effects on portfolios of country indexes using such benchmark ETFs, as they make it easy to examine the returns. Owing to their larger market capitalizations (compared to single stocks), country indexes are likely to show more persistent momentum. With this approach, investors who buy country indexes with relatively high past returns and sell country indexes with relatively low past returns earn positive risk-adjusted returns.

Understanding why the momentum factor works in country equity indexes: what academics say

Now, let’s look at research findings on the momentum factor effects on country equity indexes and their explanations.

Research findings

Muller and Ward in “Momentum effects in country equity indexes” examined the 70 country indexes that make up the MSCI world index as a representative set of global equity investment opportunities to check momentum and mean reversion effects in those indexes. The authors found that persistent and significant effects do exist, especially short-term momentum. Their result showed that, over the 39 year period from 1970 to 2009, a strategy of holding a portfolio of the four best-performing MSCI country indexes over the preceding 11 months for one month persistently out-performed an equal-weighted benchmark by around 10% per annum.

Similarly, in “Can exchange-traded funds be used to exploit country and industry momentum?”, Andreu, Swinkels, and Tjong-A-Tjoe established overwhelming empirical evidence on the existence of country and industry momentum effects. In trying to know whether country and industry momentum effects can be exploited by investors, they analyzed the profitability of country and industry momentum strategies using actual price data on ETFs and found that, over the sample periods that the ETFs were traded, an investor would have been able to exploit country and industry momentum strategies with an excess return of about 5% per annum. Since the daily average bid-ask spreads on ETFs are substantially below the implied break-even transaction costs levels, they concluded that investors can actually use ETFs to benefit from momentum effects in country and industry portfolios.

To ascertain how long the momentum factor goes in various financial markets, Geczy and Samonov in the paper, “215 Years of Global Multi-Asset Momentum: 1800-2014 (Equities, Sectors, Currencies, Bonds, Commodities, and Stocks)”, extended price return momentum tests to the longest available histories of global financial asset returns, including country-specific sectors and stocks, fixed income, currencies, and commodities. They created a 215-year history of multi-asset momentum and were able to confirm the significance of the momentum premium within and across asset classes. However, based on stock-level results, they documented a large variation of momentum portfolio betas, conditional on the direction and duration of the return of the asset class in which the momentum portfolio was built.

Interestingly, studying the profitability of a selection of prominent momentum-based strategies in the European Monetary Union, Grobys in “Another Look at Momentum Crashes” found that, in contrast to past studies documenting the lack of profitability of unconditional price momentum in the most recent decade, unconditional price momentum based on intermediate past performance — as proposed in Novy-Marx (2012) — yielded significantly positive payoffs. The author noted that although profitability was driven by the short side of the strategy, there was no evidence of any option-like behavior. But surprisingly, based on intermediate past performance, the momentum strategy generated normally distributed payoffs.

In the paper titled, “Combining Equity Country Selection Strategies”, Zaremba studied the performance of equity country selection strategies based on combinations of theoretically and empirically motivated variables. The author created portfolios and assessed their performance with asset pricing models, basing the empirical examination on data from 78 countries within the period from 1999 to 2015. It was found that, based on earnings-to-price ratio, turnover ratio, and skewness, the strategies proved useful tools for international investors. Additionally, portfolios from sorts on blended rankings of skewness combined with earnings-to-price ratio or turnover ratio were characterized by attractive risk-return relation. But the joint strategies were not found to outperform the strategies based on single metrics. On this basis, they concluded that, given the low correlations among the returns on single-variable strategies, investors would be better off building a diversified portfolio of them, rather than combining them into one strategy.

Furthermore, Zaremba in this study, “Country Selection Strategies Based on Value, Size and Momentum”, provided convincing evidence that country equity markets with, low valuation ratios, low market cap, and good past performance tend to outperform country markets with high valuation ratios, high market cap, and low momentum. The author used specific sorting procedures and conducted cross-sectional tests across 78 countries over the period 1999 to 2014, and they discovered that value, size, and momentum effects at the country level are stronger across small and medium country markets than large ones. Also, it was found that inter-market value, size, and momentum effects may be used in multifactor asset pricing models, as that perfectly explains the variation in stock returns at the country level. Hence, considering the declining benefits of international diversification observed in recent decades, the author advises investors to include country-level factor premiums in their strategic asset allocation, without shifting them to further stages of an investment process.

Similarly, considering the momentum effects in emerging markets, Urrutia and Vu, in “Do Momentum Strategies Generate Profits In Emerging Stock Markets?” investigated whether momentum strategies applied to past returns of national stock indexes generate profits in emerging capital markets of Africa, Asia, Europe, Latin America, and the Middle East. They found that momentum strategies offered extra returns that are larger for emerging markets than for developed markets. The authors also discovered that momentum profits are higher in the pre-market liberalization period than in the post-liberalization period. Thus, they postulated that the higher momentum profits generated by emerging markets were due to market isolation and that market liberalization reforms introduced in these countries tend to reduce the profits from momentum strategies.

On the aspect of risks, in the paper, “Upside and Downside Risks in Momentum Returns”, Dobrynskaya provided a novel risk-based explanation for the profitability of momentum strategies by showing that the past winners and the past losers are differently exposed to the upside and downside market risks. The author was able to show that winners systematically have higher relative downside market betas and lower relative upside market betas than losers, so the winner-minus-loser momentum portfolios are exposed to extra downside market risk but seem to hedge against the upside market risk. While such asymmetry in the upside and downside risks is a mechanical consequence of rebalancing momentum portfolios, it is unattractive for an investor because both positive relative downside betas and negative relative upside betas carry positive risk premiums when considered in the light of the Downside-Risk CAPM. As a result, they concluded that the high returns to momentum strategies are a mere compensation for their upside and downside risks.

Possible explanations

From the research findings above, it is clear that the momentum anomaly not only works in individual stocks but also performs well in country equity indexes. But what causes the anomaly, and why does it work? Many theories are thrown around to explain the persistence of the anomaly over the years. One of them is investors’ herding mentality or what is known in the market as FOMO — fear of missing out. This reverse to investors’ tendency to do what others are doing — buy what others are buying or sell what others are selling. Other reasons for the momentum anomaly include investors’ overreaction and underreaction, confirmation biases, and other behavioral biases.

In the paper, “Macromomentum: Evidence of Predictability in International Equity Markets”, Bhorjaj and Swaminathan hypothesized that the momentum and reversal patterns seem to be related to undue reactions to news about macroeconomic conditions, and not just corporate earnings. By and large, the authors were able to demonstrate the pervasiveness of momentum and reversals which support their behavioral theories.

Also, the work of Andreu, Swinkels, and Tjong-A-Tjoe in “Can Exchange-Traded Funds Be Used to Exploit Country and Industry Momentum?“ supports the existence of country and industry momentum effects by showing that purchasing index ETFs of countries and industries with relatively high past returns and selling those of countries and industries with relatively low past returns earned positive risk-adjusted returns.

Overall, many other studies, as discussed above, show that the momentum factor effect exits in country equity indexes, at least for the upside momentum, and they mostly agree that it results from investors’ behavioral biases.

How to apply this momentum factor when trading indexes

The proliferation of passive investment products makes it easy for you to invest in international markets. To exploit the momentum factor in country equity indexes, here are the steps to follow:

  1. Create an investment universe of ETFs that track individual countries’ equity indexes.
  2. Rank the country index ETFs according to their 12-month performance.
  3. Go long on the top 5 country index ETFs with the best 12– month performance.
  4. Rebalance your portfolio every month by selling any of the 5 ETFs that dropped from the top 5 and using the fund to buy the ones that replaced them in the ranking.

Note that we avoided short positions because the momentum strategy in country equity indexes performs better for the long side.


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