Momentum Factor Effect in Country Equity Indexes

No doubt, the momentum anomaly is one of the most well-known in the finance world. Moreover, this anomaly is well-researched and considered as one of the strongest anomalies. Basically, the momentum is a trend-following strategy, where the strategy buys the assets which have performed well in the past and sells the assets which have performed bad. Although the anomaly was initially discovered for stocks in just one country, since that time, the momentum has received a lot of academic interest. This has resulted in many momentum modifications, and additionally, more and more academic studies show that this anomaly is also working on country equity indexes.
The availability Exchange Traded Funds (or shortened ETFs) on stock market indices provides an attractive vehicle for investors seeking low-cost, geographically diversified assets. The MSCI World Index comprises 70 country indices, on a market capitalization-weighted basis, with no over-lapping shares. Additionally, historical total return data for the individual underlying country indices are available from their database in both local currencies and US dollars. The ETFs make it possible to examine the returns that, without the ETFs, could have been achieved only by purchasing a well-diversified, equal-weighted portfolio of country indices as a benchmark to investigate momentum effects on portfolios of country indices. Such a strategy that combines the ETFs for equity indices and the momentum is attractive because trading strategies on single shares have been shown to be ‘traded-out’ as increasing numbers of fund managers mimic the strategy. Country indices, on account of their significantly larger underlying market capitalizations, are likely to show more persistent momentum. The profitable and significant strategy would find the “winners” among the country indices and long them.

* For those interested in systematic quantitative momentum factor ETF implementation, here is a link to the Alpha Architect Quantitative Momentum ETF (strategy background), our partner. *

Fundamental reason

In terms of momentum, academics are consistent in the opinion that this anomaly works. The past research shows strong support for the momentum effects. The theory says that the main reasons for the persistence of the anomaly are behavioral biases like investor herding, investor over and underreaction, and confirmation bias.
Moreover, the additional evidence could be provided, for example, by the Bhorjaj and Swaminathan in the “Macromomentum: Evidence of Predictability in International Equity Markets“. They have examined momentum and reversals in portfolios of international stock indices, and the results indicate strong momentum up to a year following the portfolio formation date. They hypothesize that these patterns seem to be related to misreaction to news about macroeconomic conditions, not corporate earnings. Overall, their results demonstrate the pervasiveness of momentum and reversals and provide support for behavioral theories.
Even more related research is that of the Andreu, Swinkels, and Tjong-A-Tjoe: “Can exchange-traded funds be used to exploit country and industry momentum?“. According to those authors, there is overwhelming empirical evidence on the existence of country and industry momentum effects. This line of research suggests that investors who buy countries and industries with relatively high past returns and sell countries and industries with relatively low past returns will earn positive risk-adjusted returns. However, as they stress out, these studies focus on country and industry indexes that cannot be traded directly by investors. Therefore, they have analyzed the profitability of country and industry momentum strategies using actual price data on Exchange Traded Funds. Over the sample periods that these ETFs were traded, an investor would have been able to exploit country and industry momentum strategies with an excess return of about 5% per annum. The daily average bid-ask spreads on ETFs are substantially below the implied break-even transaction costs levels. Hence, they have concluded that investors that are not willing or able to trade individual stocks can use ETFs to benefit from momentum effects in country and industry portfolios.

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Markets Traded

Backtest period from source paper

Confidence in anomaly's validity

Indicative Performance

Notes to Confidence in Anomaly's Validity

Notes to Indicative Performance

per annum, performance depends on chosen lookback and holding periods, data from Figure 13

Period of Rebalancing

Estimated Volatility

Notes to Period of Rebalancing

Notes to Estimated Volatility

not stated

Number of Traded Instruments

Maximum Drawdown

Notes to Number of Traded Instruments

Notes to Maximum drawdown

not stated

Complexity Evaluation
Simple strategy

Sharpe Ratio

Notes to Complexity Evaluation

United States

Financial instruments
ETFs, funds

Simple trading strategy

The investment universe consists of ETFs (funds) which invest in individual countries’ equity indexes. The top 5 countries with the best X – month (where X depends on investors choice, studies show X to be best as 10-12) momentum are chosen as an investment, and portfolio is rebalanced once in a month.

Hedge for stocks during bear markets

No - Momentum in country equity indexes is a long-only strategy and, as such, has a strong exposition to equity market risk. The tendency of momentum to pick strongly performing but often small and emerging countries into portfolio during the late stage of the business cycle (when these countries usually overperform) also doesn’t help – country momentum has higher equity beta during this time and falls faster than benchmark portfolio.

Source paper
Out-of-sample strategy's implementation/validation in QuantConnect's framework (chart+statistics+code)
Other papers

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