Momentum Factor and Style Rotation Effect

Academics have shown that momentum strategies can generate extraordinary excess returns in virtually every asset class (stocks, FX, commodities) or their respective parts (equity sectors, industries, countries). This includes momentum into the standard strategy set of nearly each portfolio manager.

But is momentum applicable also to market anomalies or factor portfolios? Yes, it is. Multiple research papers show it is possible to apply momentum strategies to successfully rotate between equity styles (small-cap value, large-cap growth, etc.). The beauty of this approach is its simplicity (as various equity styles portfolios are easily accessible via ETFs) and the practically zero correlation to the broad equity market (if the investor uses the long-short version of this strategy), which makes this it an easily accessible, good portfolio diversifier.

Fundamental reason

The obvious observation is that styles perform differently over time (the same way different assets do). The popularity of style investing itself may influence the structure and dynamics of asset returns since prices deviate substantially from fundamental values as styles become popular or unpopular. This non-random behavior gives the foundation to the rise of exploitable momentum.

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Markets Traded
equities

Financial instruments
ETFs

Confidence in anomaly's validity
Strong

Backtest period from source paper
1972-2005

Notes to Confidence in Anomaly's Validity

Indicative Performance
9.25%

Period of Rebalancing
Monthly

Notes to Indicative Performance

per annum, long short strategy, data from table 3


Notes to Period of Rebalancing

Estimated Volatility
16.01%

Number of Traded Instruments
6

Notes to Estimated Volatility

long short strategy, data from table 3


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
0.33

Simple trading strategy

Russell’s ETFs for six equity styles are used (small-cap value, mid-cap value, large-cap value, small-cap growth, mid-cap growth, large-cap growth). Each month, the investor calculates 12-month momentum for each style and goes long on the winner and short on the loser. The portfolio is rebalanced each month.

Hedge for stocks during bear markets

Not known - Source and related research papers don’t offer insight into the correlation structure of the proposed trading strategy to equity market risk; therefore, we do not know if this strategy can be used as a hedge/diversification during the time of market crisis. The strategy is built as a long-short, but it can be split into two parts. The long leg of the strategy is surely strongly correlated to the equity market; however, the 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
Strategy's implementation in QuantConnect's framework (chart+statistics+code)
Other papers

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