We have already documented the returns to generic momentum investing strategies. Within the fund marketplace, many investors focus on fees and less on process. For example, Morningstar highlights the fees as "cost-efficient" for a specific momentum fund, MTUM. However, fees are only one part of an investment decision--process also matters--especially when it comes to momentum-based stock selection strategies. Here we hope to document how portfolio construction (number of stocks, holding period, and weightings) affects returns. Our bottomline is as follows:
- Holding period matters: more frequent trading increases gross returns
- Portfolio size matters: more concentration increases gross returns
Our analysis of momentum investment strategiesWe examine the top 1,000 largest US-exchange-traded common stocks each month (we eliminate REITs, ADRs, ETFs, and Closed-End Funds). We calculate the momentum variable as the cumulative returns over the past 12 months, ignoring the past month (academic construction). We allow the portfolio construction to vary across two dimensions:
- First, we examine the returns by varying the number of firms in the portfolio. We allow the portfolio size to vary from 50 to 500 stocks (Universe is the largest 1,000 stocks).
- Second, we examine the returns by varying the holding periods. We allow the holding periods to vary from 1 month to 12 months.
Portfolio PerformanceThe results below reflect the compound annual growth rates for the various strategies from 1970-2016 for both value-weight and equal-weight portfolios. The value-weight monthly rebalanced 50 stock momentum strategy earns 17.36% CAGR, whereas the annually rebalanced 500 stock portfolio earns 10.89% CAGR. Important to note, all of these results are GROSS of transaction costs.
Value-weight Portfolios (1970-2016)
Equal-weight Portfolios (1970-2016)Clearly, there is a relationship between the number of firms, the holding period, and returns.
- The holding period is important. Holding the number of firms constant, the lower the holding period, the higher the CAGR. For the value-weight portfolios holding 50 stocks, the CAGR falls from 17.36% when holding the stocks for 1 month, to 11.42% when holding the stocks for 12 months.
- The number of firms is important. If we keep the holding period constant, the less firms in the portfolio, the higher the CAGR. For the value-weight portfolios with a holding period of one month, the CAGR falls from 17.36% when selecting the top 50 stocks, to 12.12% when selecting the top 500 stocks.
Digging a little deeper into the resultsLet's examine the returns (with some more advanced statistics) on two portfolios. First, we will examine the 50 stock, 3-month holding period portfolio (equal-weighted), and compare this to a 150 stock, 6-month hold "low cost" momentum portfolio (value-weighted). Here are the portfolios we examine:
- 50 stocks, 3M hold, EW = Top 50 firms ranked on momentum, held in the portfolio for 3 months. Portfolio is equal-weighted.
- 150 stocks, 6M hold, VW = Top 150 firms ranked on momentum, held in the portfolio for 6 months. Portfolio is value-weighted.
- VW Universe = Returns to the universe of the top 1,000 firms on market capitalization (with 12-month momentum calculation). Portfolio is value-weighted.
- SP500 = S&P 500 Total return
- Low scalability, high expected performance strategy: 50 stock quarterly rebalanced; 100bps management fee, 25bps rebalance fee
- 100bps + 4*25bps = 200bps in costs
- Gross CAGR = 16.87%, Net CAGR ~ 14.87%
- High scalability, lower expected performance strategy: 150 stock semi-annual rebalance; 25bps management fee, 25bps rebalance fee
- 25bps + 2*25bps = 75bps in costs
- Gross CAGR = 13.01%, Net CAGR ~ 12.26%
Learning PointsThis simple discussion should highlight a few things:
- Momentum works on a gross of fee basis.
- Momentum works even better when it is concentrated and traded frequently.
- A buyer of momentum products need to consider construction, asset scale, and trading capability of an asset manager before selecting a momentum fund
- The ideal momentum product built for expected performance is concentrated (~50 stocks), has high turnover (monthly-quarterly rebalance), and limited AUM (<$1B)