Cross-sectional momentum is one of those strategies that backtests beautifully, earns nods at quant conferences, and then occasionally faceplants in live trading while you stare at your screen wondering what went wrong. The culprit is usually hiding in plain sight: sector concentration. On a deep, diversified index like the S&P500, concentration risk is manageable. On the ASX200? It's a different beast entirely.

The ASX200 is famously top-heavy. Financials and materials together routinely account for more than 50% of index weight. When momentum signals fire, they tend to cluster — you're not picking the top 20 stocks across the economy, you're often picking the top 20 stocks from two sectors having a good quarter. Your "diversified" momentum portfolio is quietly wearing a single-sector costume to a fancy-dress party.

CONCEPTCross-sectional momentum ranks stocks by recent returns and goes long winners — but on the ASX200, winners tend to travel in sector packs.
WARNINGSector concentration can inflate backtest Sharpe ratios by making correlated bets look like independent alpha — until a sector rotates hard.
KEY IDEANeutralising sector exposure in your momentum model separates genuine stock-level alpha from sector drift dressed up as skill.

Here's the mechanical problem. Standard cross-sectional momentum ranks every stock in the universe by its trailing return — typically 12 months minus the most recent month — and buys the top decile. When mining stocks have run hard for three quarters, your top decile is stuffed with BHP, RIO, and twenty of their closest friends. These positions are not independent bets. They're one bet, wearing different ticker symbols.

Top Decile Momentum — Sector BreakdownMaterialsFinancialsEnergyHealthConsumerOtherWeight %38%26%10%8%6%5%

The fix most systematic traders reach for is sector-neutral momentum — ranking stocks within each sector rather than across the entire index. You're still buying winners, but winners relative to their sector peers. This preserves the stock-level signal while stripping out the sector drift. Think of it like judging a cooking competition within cuisine categories rather than forcing a sushi chef to compete against a pastry chef on the same judging rubric.

Sector-neutral approaches do compress raw returns — you're giving up the free kick of riding a hot sector. But the Sharpe ratio typically improves because your volatility drops faster than your returns do. Correlated positions in a momentum crash — like the brutal 2009 reversal — can slash a naive momentum portfolio in weeks. Neutralising sector exposure softens that drawdown considerably. For a deeper grounding in the mechanics, Investopedia's momentum explainer covers the foundational theory well, while Wikipedia's momentum investing article traces the academic lineage from Jegadeesh and Titman forward. For index composition context specifically relevant to Australian portfolios, the S&P/ASX 200 Wikipedia page gives a clear breakdown of how concentrated this index actually is.

Run your momentum backtest twice — once raw, once sector-neutralised — and watch where the Sharpe difference lives. That gap is concentration risk pretending to be alpha.

This content is for educational purposes only and does not constitute financial product advice. Past performance is not indicative of future results. Profit Logic Ltd (ACN 688 669 936) accepts no responsibility for errors or omissions in this content or anywhere on this website. Always seek advice from a licensed financial adviser before making investment decisions.