Trend Following and Momentum Strategies › Limitations and Practical Considerations

Momentum strategies, while historically profitable, face several practical challenges that affect real-world implementation.

Transaction costs represent a significant drag on momentum returns. High-turnover strategies that frequently rebalance between winners and losers incur substantial trading costs, particularly when dealing with less liquid securities. Studies that account for realistic transaction costs often find that momentum profits are substantially reduced, especially for strategies using shorter formation and holding periods. You must carefully balance signal freshness against turnover, often implementing partial rebalancing or threshold-based trading rules to reduce costs.

The risk of regime change poses an existential threat to momentum strategies. The anomaly has been documented extensively since the 1990s, attracting substantial capital to momentum-based strategies. As more assets chase the same patterns, the equilibrium expected return should decline. Some researchers argue that momentum profits have already diminished in recent decades, while others contend that the behavioral roots of momentum ensure its persistence. Regardless, you should expect future returns to be lower than historical backtests suggest and should continuously monitor for signs of strategy decay.

Short-selling constraints create asymmetry between the long and short legs of cross-sectional momentum. Shorting stocks involves borrowing costs, potential recalls, and regulatory restrictions that do not affect long positions. Additionally, the short leg often consists of distressed or high-volatility stocks that are difficult and expensive to borrow. Many implementations of momentum focus primarily on the long leg or use long-only momentum-tilted portfolios rather than attempting dollar-neutral long-short strategies.

Finally, momentum strategies interact with other factors in ways that can reduce or enhance returns. Momentum tends to be negatively correlated with value strategies at short horizons, as recent winners often appear expensive while recent losers appear cheap. This creates natural hedging opportunities when combining momentum with value in multi-factor portfolios. We will explore these factor interactions further in the next chapter on Factor Investing and Long/Short Equity.