Consistent Momentum Strategy

The traditional momentum effect is one of the most well-known and best documented stock market anomalies. Also, some notable research about the persistency of momentum effect has already taken place at the portfolio level (for example Chen et al., 2014). However, recent research has taken the issue a bit further, focusing on the performance variation at the firm level rather than on more general portfolio level. Based on the ‚top decile long and bottom decile short‘ approach, the empirical evidence shows, inter alia, that only about 60% of the winner/loser stocks in the sample were consistent winners (losers) - in the top (bottom) decile both during the month of portfolio formation and in the following month - and that at least 1/4 of them even experienced a contrarian effect in the post-formation month. The authors of the recent academic research show that consistent winner stocks outperform inconsistent winner stocks, and conversely, consistent loser stocks underperform inconsistent loser stocks, in the post-formation period. With respect to this result, they suggested a strategy of buying consistent winners while selling consistent losers, which outperformed the traditional and 'inconsistent' momentum with 1.25% average monthly return (significantly positive even after adjusting for Fama-French‘s three factors and Carhart’s momentum factor, as opposed to the traditional and inconsistent momentum strategies with 1.06% and 0.47% average monthly returns, respectively).

Fundamental reason

Momentum anomaly is, in general, related to investors' irrationality - they underreact to new information as they do not incorporate news in their transaction prices sufficiently. In accordance with the information asymmetry and the heterogenous beliefs hypotheses,the persistence of momentum effect depends on size, idiosyncratic volatility, % of institutional ownership, and trading volume. According to the former, investors tend to be conservative in the case of stocks with higher idiosyncratic volatilities and lower percentage of outstanding stocks owned by institutional investors (they become consistent winners/losers due to slow price adjustment). The latter suggests that higher trading volume on stock (proxy for disagreement among investors) should produce stronger momentum effect.

Markets traded
equities
Confidence in anomaly's validity
Strong
Notes to Confidence in anomaly's validity
Period of rebalancing
6 Months
Notes to Period of rebalancing
Number of traded instruments
1000
Notes to Number of traded instruments
more or less, it depends on investor's need for diversification
Complexity evaluation
Complex strategy
Notes to Complexity evaluation
Strategy complexity depends on number of stocks investor wishes to include into his/her portfolio, as strategy could be much simpler for execution if investor picks less stocks.
Financial instruments
stocks
Backtest period from source paper
1980-2011
Indicative performance
16.08%
Notes to Indicative performance
per annum, annualized (geometrically) average monthly return of 1,25%, data from table 9
Estimated volatility
25.33%
Notes to Estimated volatility
estimmated from t-statistic, data from table 9
Maximum drawdown
not stated
Notes to Maximum drawdown
Sharpe Ratio
0.48

Keywords:

stock picking, momentum, momentum in stocks, equity long short

Simple trading strategy

The investment universe consists of stocks listed at NYSE, AMEX, and NASDAQ, whose price data (at least for past 7 months) are available at CRSP database. The investor creates a zero-investment portfolio at the end of the month t, longing stocks that are in the top decile in terms of returns both in the period from t-7 to t-1 and from t-6 to t, while shorting stocks in the bottom decile in both periods (i.e. longing consistent winners and shorting consistent losers). The stocks in the portfolio are weighted equally. The holding period is six months, with no rebalancing during the period. There is a one-month skip between formation and holding period.

Hedge for stocks during bear markets

Not known - Source and related research papers don't offer insight into correlation structure of proposed trading strategy to equity market risk, therefore we do not know if this strategy can be used as a hedge/diversification during time of market crisis. Strategy is built as a long-short, but it can be split into 2 parts. Long leg of strategy is surely strongly correlated to equity market however short-only leg can be maybe used as a hedge during bad times. Rigorous backtest is however needed to determine return/risk characteristics and correlation.

Source Paper

Chen, Chou, Hsieh: Persistency of the Momentum Effect: The Role of Consistent Winners and Losers
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2652592
Abstract:
Momentum profits, resulting from buying winners and selling losers, are robust in the stock market; however, less than 60% of winner and loser stocks remain in winner and loser groups in the subsequent formation month. This study applies duration analysis to test the persistency of the momentum effect and demonstrates that consistent winners and losers experience higher subsequent momentum profits than inconsistent winners and losers. Consistent with the information asymmetry hypothesis and the heterogeneous beliefs hypothesis, the momentum persistency is associated with size, idiosyncratic risk, institutional ownership, and trading volume. In addition, an asymmetric effect is observed—the post-formation return contributes to the winner persistency more, while the formation period return can explain the loser persistency more. The duration analysis also demonstrates that the trading volume reflects effects of both heterogeneous beliefs among investors and the momentum life cycle. The consistent momentum strategy may offer enhanced performance, despite controlling for factors associated with
market risk, size, book-to-market ratio, momentum effect, and liquidity risk.

Hypothetical future performance

Other Papers