Research into the momentum factor continues to demonstrate its persistence and pervasiveness, including across factors. Recent papers have focused on trying to identify ways to improve the explanatory power and performance of momentum strategies.
Prior research on Momentum
The study “Momentum Has Its Moments” found that momentum strategies can be improved by scaling for volatility—targeting a specific level of volatility, reducing (increasing) exposure when volatility is high (low).
The study “Enhanced Momentum Strategies” confirmed that both scaling volatility and idiosyncratic momentum are unique strategies that decrease momentum crashes and lead to higher risk-adjusted returns—with idiosyncratic momentum emerging as the best momentum strategy.
The study “Momentum and Reversal: Does What Goes Up Always Come Down?” found that the stocks in a momentum portfolio, which contribute to momentum profits, do not experience significant subsequent reversals. Conversely, stocks that do not contribute to momentum profits over the intermediate horizon exhibit subsequent reversals. Merging these separate securities into a single portfolio causes momentum and reversal patterns to appear linked. Stocks with momentum can be separated from those that exhibit reversal by sorting on size and book-to-market (BtM) equity ratio. A strategy of buying small value winners and selling large growth losers yields larger momentum profits than the standard momentum strategy in the short run and doesn’t display significant return reversals for holding periods beyond one year.
Latest Contribution to the Literature
By examining international
evidence, Christian Walkshäusl, Florian Weißofner and Ulrich Wessels provide an
out-of-sample test of the findings of the “Momentum and Reversal: Does What
Goes Up Always Come Down?” study. Their study, “Separating
Momentum from Reversal in International Stock Markets,” which appears in the January 2019 issue of the
Journal of Asset Management, covers 20 developed international markets and the
period July 1990-June 2017. They excluded very small firms by eliminating the 5
percent with the lowest market equity in each country. They also excluded
negative book equity and financial firms.
Following the methodology of Conrad and Yavuz, authors of the aforementioned “Momentum and Reversal” study, the stocks in the long leg of the portfolio are those with the following characteristics:
six-month returns in the top tercile of the momentum distribution.
size in the bottom tercile of the size distribution.
ratio in the top tercile of that distribution.
Thus the long leg is full of firms classified as small value winners. The stocks in the short leg have these characteristics:
six-month returns in the bottom tercile of the momentum distribution.
size in the top tercile of the size distribution.
ratio in the bottom tercile of that BtM distribution.
Thus classifying the firms in the short leg as large growth losers. That combined long/short portfolio is referred to as the MAX strategy. For the MIN strategy, the indicator variables are defined in an analogous manner, using the tercile classifications based on size, BtM, and momentum. Specifically, long is a large growth winner and short is a small value loser.
Summary of the Findings
Taking into account expected return characteristics like firm size and BtM in the selection of winners and losers helps to ex-ante separate stocks with momentum from those that exhibit reversal in international equity markets—confirming that momentum and reversals are not necessarily linked.
A strategy that buys small value winners and sells large growth losers (MAX strategy) generates significantly larger momentum profits than a standard momentum strategy, is robust to common return controls and does not suffer from return reversals for holding periods up to 3 years.
The superior performance of the strategy is attributable to a systematic exploitation of cross-sectional mispricing among momentum stocks.
The strategy is implementable, with estimated trading costs of about 0.54 percent per annum versus a premium of greater than 7.5 percent.
The findings are robust to subsample periods, firm size, economic regime, and region (with the exception of Japan, a well-documented exception to the pervasiveness of the momentum factor).
Specifically, they found that, with
the MAX strategy (the long leg consists of winners with high expected return
characteristics—small and value—and the short leg is based on losers with low
expected return characteristics—large and growth), the attainable momentum
premium is economically and statistically greatly enhanced at 7.34 percent per
year (more than twice that of the 3.57 percent return of the simple momentum
strategy). The average return premium is equally driven by the strategy’s long
leg as well as the short leg. In contrast, when the MIN strategy is considered,
where the long leg consists of winners with low expected return characteristics
(large and growth), and the short leg is based on losers with high expected
return characteristics (small and value), the momentum premium is a
statistically insignificant 1.20 percent per year.
Summarizing, these findings help us better understand the explanatory power of momentum in the cross-section of expected returns and can be used to create more efficient portfolios, whether long-only or long/short. They also show the benefit of combining multifactor portfolio strategies into one single fund versus the alternative of building portfolios of funds that obtain exposure to single factors.
As Chief Research Officer for Buckingham Strategic Wealth and Buckingham Strategic Partners, Larry Swedroe spends his time, talent and energy educating investors on the benefits of evidence-based investing with enthusiasm few can match. Larry was among the first authors to publish a book that explained the science of investing in layman’s terms, “The Only Guide to a Winning Investment Strategy You’ll Ever Need.” He has since authored seven more books: “What Wall Street Doesn’t Want You to Know” (2001), “Rational Investing in Irrational Times” (2002), “The Successful Investor Today” (2003), “Wise Investing Made Simple” (2007), “Wise Investing Made Simpler” (2010), “The Quest for Alpha” (2011) and “Think, Act, and Invest Like Warren Buffett” (2012). He has also co-authored eight books about investing. His latest work, “Your Complete Guide to a Successful and Secure Retirement was co-authored with Kevin Grogan and published in January 2019. In his role as chief research officer and as a member of Buckingham’s Investment Policy Committee, Larry, who joined the firm in 1996, regularly reviews the findings published in dozens of peer-reviewed financial journals, evaluates the outcomes and uses the result to inform the organization’s formal investment strategy recommendations. He has had his own articles published in the Journal of Accountancy, Journal of Investing, AAII Journal, Personal Financial Planning Monthly, Journal of Indexing, and The Journal of Portfolio Management. Larry’s dedication to helping others has made him a sought-after national speaker. He has made appearances on national television shows airing on NBC, CNBC, CNN, and Bloomberg Personal Finance. Larry is a prolific writer and contributes regularly to multiple outlets, including Advisor Perspective, Evidence Based Investing, and Alpha Architect. Before joining Buckingham Wealth Partners, Larry was vice chairman of Prudential Home Mortgage. He has held positions at Citicorp as senior vice president and regional treasurer, responsible for treasury, foreign exchange and investment banking activities, including risk management strategies. Larry holds an MBA in finance and investment from New York University and a bachelor’s degree in finance from Baruch College in New York.
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