Momentum investors utilize different timeframes to identify high momentum equities: past 6, 9, 12 months as an example. Obviously, there is a significant degree of overlap in momentum stocks identified across various past time frames. However, there has been little research focused on understanding the characteristics of momentum stocks formed on six and 12 months that overlap one another. The authors refer to the subset as “overlapping” stocks and suggest they constitute the largest proportion of the profitability of the momentum strategy.
Using a database of returns covering the years 1928 to 2018, portfolio returns were constructed for past winners and past losers, across a number of past formation periods of varying lengths. The stocks that were simultaneously found in each of the portfolios were examined as to the continued pattern of return. The stocks found in the top decile of momentum based on both the past 6-month and past 12-month return were designated as the “winners”. The “losers” were comprised of the overlapping stocks from the bottom decile based on momentum and from the 6th and 12th month formation periods. The long/short portfolio was then designated OMOM.
What are the Academic Insights?
The OMOM portfolios produced a return of 3.69% over the non-overlapping portfolio using a 12-month formation period. The 3.69% was calculated over a 9-month holding period and was statistically significant. Similar results were found when a 6-month holding period was used. Given the design, it is safe to conclude that the results do not rely on overlapping stocks producing very extreme returns close to the formation date.
The outperformance of the OMOM portfolio is not explained by higher risk, as measured the CAPM, 3-Factor and 5-Factor FF models. In addition, the OMOM portfolios exhibited higher annualized Sharpe Ratios, lower downside risk and lower tail risk. A long position in overlapping winner stocks and short in overlapping losers is not explained by transactions costs, seasonal effects, or observation periods.
Why does it matter?
It appears that the superior performance of OMOM portfolios is due to the overlapping momentum stocks falling into the cross-section of momentum traders with different formation periods. Although it seems obvious, this phenomenon has largely gone unnoticed (at least by me). The authors show that the capitalizing on the differences in the formation periods has a significant impact on the profitability of momentum strategies.
The most important chart from the paper
The results are hypothetical results and are NOT an indicator of future results and do NOT represent returns that any investor actually attained. Indexes are unmanaged and do not reflect management or trading fees, and one cannot invest directly in an index.
Different momentum investors use different formation periods to evaluate past stock performance. We explore the consequences of this diversity by studying the stocks that are the likely constituents of the portfolios of the heterogeneous momentum investors that coexist in practice. We show that stocks in the intersection of the 6 and 12-month momentum portfolios – ‘‘overlapping’’ momentum stocks – display enhanced medium-term return momentum. This finding is robust to considering a broad set of risk factors, transaction costs, and alternative explanations. Focusing on overlapping momentum stocks improves the returns of several momentum-based strategies proposed in the literature. The results are in line with the concurrence of trades by heterogeneous momentum investors exacerbating return continuation.
Dr. Tommi Johnsen was a past Director of the Reiman School of Finance and a tenured faculty at the Daniels College of Business at the University of Denver. She has worked extensively as a consultant and investment advisor in the areas of quantitative methods and portfolio construction. She taught at the graduate and undergraduate level and published research in several areas: capital markets, portfolio management and performance analysis, financial applications of econometrics, and the analysis of equity securities. Her publications have appeared in numerous peer-reviewed journals.
Performance figures contained herein are hypothetical, unaudited and prepared by Alpha Architect, LLC; hypothetical results are intended for illustrative purposes only. Past performance is not indicative of future results, which may vary. There is a risk of substantial loss associated with trading stocks, commodities, futures, options and other financial instruments. Full disclosures here.