Optimization of Equity Momentum

#14 – Momentum Effect in Stocks

Authors: van Oord

Title: Optimization of Equity Momentum: (How) Does it Work?

Link: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2653680
 

Abstract:

Standard mean-variance optimized momentum outperforms the traditional equally weighted momentum strategy if the expected return vector used reflects momentum's top and bottom only characteristic. This top and bottom only characteristic is the phenomenon that only the stocks in the top decile of momentum's ranking outperform and that only stocks in the bottom decile underperform, while all stocks in the intermediate deciles of the ranking have similar performance. If the optimization does not take this phenomenon into account the portfolio is also long the deciles 2 to 5 and short the deciles 6 to 9, while all these positions thus do not add anything to the return of the strategy. A new simplified bootstrapping methodology shows that the Sharpe-ratio of 52.8 percent of the optimized portfolio is significantly higher (p-value of 0.006) than the Sharpe-ratio of 29.3 percent for traditional equally weighted momentum. The optimized portfolio also exhibit less time-varying equity risk factor return exposures than traditional momentum and as such have more stable returns over the business cycle and have smaller drawdowns.

Notable quotations from the academic research paper:

"The traditional momentum strategy ranks stocks on their recent 3 to 12 months average returns, skips one month to overcome short-term return reversals and then buys the stocks in the top decile of the ranking and short-sells the stocks in the bottom decile of this ranking. Jegadeesh and Titman (1993) show that this traditional momentum strategy has a signi cant positive average return. Using standard mean-variance optimization with these recent average stock returns as input for the expected returns results in a signi cantly higher Sharpe-ratio than the traditional momentum strategy if the expected returns reflect momentum's top and bottom only characteristic.

We show that the momentum is a top and bottom only strategy. Given momentum's signi cant outperformance of the top decile over the bottom decile of its ranking on the stocks' recent performance one would expect that stocks in the second decile would also outperform stocks in the ninth decile. This is, however, not the case: all stocks in the second to ninth decile have similar performance. When using the recent stocks' performances as expected returns
in the optimization thus results in long positions in the second to fth decile and short positions in the sixth to ninth deciles. These long-short positions do not add to the performance as they have similar returns. In fact, these positions decrease momentum's performance as they reduce the weights in the top and bottom decile that do outperfom each other and do add to the performance."


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