Momentum Effect in Stocks in Small Portfolios

The momentum anomaly is one of the strongest and oldest academically described anomalies. However, is it easily exploitable?

Academic research usually uses portfolios filled by thousands of stocks to compute momentum factor returns. But this is not possible for small retail investors with small portfolios. They are constrained compared to big hedge funds and cannot diversify so well. Recent academic research shows that a small portfolio is not a problem in momentum investing. The momentum effect could be easily captured even with a portfolio consisting of up to 50 stocks.

Fundamental reason

Academic studies show strong support for momentum effects. The main reasons for anomaly persistence are behavioral biases like investor herding, investor over and underreaction, and confirmation bias. Another natural interpretation of momentum profits is that stocks underreact to information. For example, if a firm releases good news, and the stock price only reacts partially to the good news, then buying the stock after the initial release of the news will generate profits.

Get Premium Trading & Strategy Ideas

  • Unlocked Screener & Advanced Charts
  • 370+ uncommon trading strategy ideas
  • New strategies on a bi-weekly basis
  • 800+ links to academic research papers
  • 100+ out-of-sample backtests
Markets Traded
equities

Financial instruments
stocks

Confidence in anomaly's validity
Moderately Strong

Backtest period from source paper
1988-2006

Notes to Confidence in Anomaly's Validity

Indicative Performance
32%

Period of Rebalancing
Yearly

Notes to Indicative Performance

net return per annum, annualized (geometrically) monthly return 2.34%, data from table 6 assuming 10 000 pounds in a portfolio and 10 stocks long/short, return could be enhanced by lowering number of stocks in a portfolio or by having more money (lower impact of fees)


Notes to Period of Rebalancing

Estimated Volatility
0%

Number of Traded Instruments
20

Notes to Estimated Volatility

not stated


Notes to Number of Traded Instruments

Maximum Drawdown
0%

Complexity Evaluation
Simple strategy

Notes to Maximum drawdown

not stated


Notes to Complexity Evaluation

Sharpe Ratio
0

Simple trading strategy

The investment universe consists of all UK listed companies (this is the investment universe used in the source academic study, and it could be easily changed into any other market – see Ammann, Moellenbeck, Schmid: Feasible Momentum Strategies in the US Stock Market). Stocks with the lowest market capitalization (25% of the universe) are excluded due to liquidity reasons. Momentum profits are calculated by ranking companies based on their stock market performance over the previous 12 months (the rank period). The investor goes long in the ten stocks with the highest performance and goes short in the ten stocks with the lowest performance. The portfolio is equally weighted and rebalanced yearly. We assume the investor has an account size of 10 000 pounds.

Hedge for stocks during bear markets

No - Pure long-only equity momentum strategy implicitly can’t be used as a hedge. The long-short equity momentum factor is also troublesome for hedging as a momentum factor is prone to “momentum crashes”. Equity momentum factor performs well during the first stages of crises (as it usually shorts stocks with strong downward momentum and buys stocks which are not falling fast). Momentum crashes usually occurred right as the market rebounded following previous large declines. One explanation for this pattern is the time-varying systematic risk of the momentum strategy because momentum has significant negative beta following bear markets. Numerous amended versions of the basic momentum strategy appeared after the 2008 bear market. These adjusted strategies may offer a better hedge against equity market risk.

Source paper
Strategy's implementation in QuantConnect's framework (chart+statistics+code)
Other papers

Get Quantpedia Premium

  • Unlocked Screener & Advanced Charts
  • 380+ uncommon trading strategy ideas
  • New strategies on a bi-weekly basis
  • 800+ links to academic research papers
  • 120+ out-of-sample backtests

Subscribe for Newsletter

Be first to know, when we publish new content


logo
The Encyclopedia of Quantitative Trading Strategies

Log in