Conventional momentum is a very well known anomaly; therefore, it is scrutinizingly studied. This strategy has been academically confirmed many times, but a lot of researchers have documented several momentum drawbacks. One important characteristic is that traditional momentum has substantial time-varying exposures to the classical Fama and French factors. Academic research shows that momentum loads positively (negatively) on systematic factors when these factors have positive (negative) returns during the formation period of the momentum strategy. As a consequence, a conventional total return momentum strategy experiences losses when the sign of the factor returns over the holding period is opposite to the sign over the formation period. One example is that negative market returns in the credit crises of 2008 caused the total return momentum to be tilted towards the low-beta segment of the market in early 2009. When the market recovered in the first quarter of 2009, the total return momentum’s negative market beta caused large losses. Luckily, the same academic research offers a solution. A residual momentum strategy based on residual returns estimated using the Fama and French three-factor model offers smaller time-varying factor exposures (which reduces the volatility of the strategy). It has a higher long-run average Sharpe ratio. A higher strategy consistency, large-cap investment universe, and a lower concentration in the extremes of the cross-section of stocks is an added bonus.

* For those interested in systematic quantitative momentum factor ETF implementation, here is a link to the Alpha Architect Quantitative Momentum ETF (strategy background), our partner. *

As it is mentioned in the “Description”, a residual momentum strategy uses the Fama and French three-factor model to remove the classical momentum strategy’s dependence on systematic factors. The residual momentum is closer to being factor neutral than total return momentum, which adds a lot of benefits.