A New Analysis of Commodity Momentum Strategy
A related paper has been added to:
#21 – Momentum Effect in Commodities
Authors: Bianchi, Drew, Fan
Title: Microscopic Momentum in Commodity Futures
Conventional momentum strategies rely on 12 months of past returns for portfolio formation. Novy-Marx (2012) shows that the intermediate return momentum strategy formed using only twelve to seven months of returns prior to portfolio formation significantly outperforms the recent return momentum formed using six to two month returns prior. This paper proposes a more granular strategy termed ‘microscopic momentum’, which further decomposes the intermediate and recent return momentum into single-month momentum components. The novel decomposition reveals that a microscopic momentum strategy generates persistent economic profits even after controlling for sector-specific or month-of-year commodity seasonality effects. Moreover, we show that the intermediate return momentum in the commodity futures must be considered largely illusory, and all 12 months of past returns play important roles in determining the conventional momentum profits.
Notable quotations from the academic research paper:
"In this study, we propose a third type of momentum strategy termed Microscopic Momentum, which further decomposes the recent (6 to 2 months) and intermediate (12 to 7 months) momentum of Novy-Marx (2012) into 12 single-month individual momentum components. As a consequence of the decomposition, we are able to take a glimpse at momentum profits under a month-by-month, microscopic scale. For the first time, this novel approach not only reveals a striking new discovery of a momentum based anomaly, but also allows us to pinpoint whether specific months in the past play a more significant role in determining conventional and echo momentum profits, hence it offers fresh insights into our understanding of momentum in commodity futures.
The proposed granular analysis of microscopic momentum makes four major contributions to the commodity futures literature. First, in the commodity futures markets, the ‘11,10 microscopic momentum strategy’, constructed using the 11 to 10-month return prior to formation, produces an annualised average return of 14.74% with strong statistical significance. The superiority of the 11,10 strategy is not driven by sector-specific nor month-of-year commodity seasonality effects and is robust across sub-periods and out-of-sample analysis.
Second, when the RNM echo momentum is regressed against its microscopic components, RNM intermediate momentum can be completely subsumed by the 11,10 microscopic momentum. Thus, the superior performance of intermediate momentum claimed by RNM may be an illusion created by the 11,10 microscopic momentum. This implies that for tactical asset allocation decisions, CTAs and commodity fund managers must not consider intermediate momentum as a viable substitute for conventional momentum strategies. Instead, the 11,10 microscopic strategy, which offers similar profits in magnitude but unique dynamics of returns to conventional strategies, may be a feasible alternative.
Third, around 77% of the variation of returns in the JT conventional momentum strategy can be explained by its microscopic decomposition. However, since no dominance is found on any individual month, all past months are found to be important in determining the conventional commodity momentum profits.
Fourth, echo and microscopic momentum is partially related to the U.S. cross-sectional equity momentum and the returns from broad commodity futures, but is not related to stocks, bonds, foreign currency risks and macroeconomic conditions. Consistent with Asness et. al., (2013), this finding implies that there may indeed be a common component in momentum across asset classes."
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