Momentum is the tendency of investments to persist in their performance. Assets that perform well over a 3 to 12 month period tend to continue to perform well into the future. The momentum effect of Jegadeesh and Titman (1993) is one of the strongest and most pervasive financial phenomena. Momentum investment strategies have been mostly applied to equities (see momentum factor in stocks), however there is large evidence documenting this effect across different asset classes. Typical strategy consists of a universe of major indices on equity, bonds, real estate and commodities. The aim is to keep long only portfolio where an index with positive past 12 month returns is bought and negative returns sold. A well-known example of trend following momentum strategy is from Faber (2007). He creates 10 month moving average for which assets are sold and bought every month based on price being above or below the moving average. Using a 100 years of data, Faber claims to outperform the market with the mean return of 10.18% , 11.97 % volatility and max draw-down of 50.29%, compared to S&P 500 return of 9.32%, volatility of 17.87% and max draw-down of 83.46%.
In general, we distinguish between absolute (time-series momentum) and relative momentum. Absolute momentum is captured by trend following strategies that adjusts weights of assets based on past returns such as relative level of current prices compared to moving averages. Relative or cross sectional momentum anomaly, on the other hand, use long and short positions applied to both the long and short side of a market simultaneously. It makes little difference whether the studied markets go up or down, since short momentum positions hedge long ones, and vice versa. When looking only at long side, however, it is desirable to be long only when both absolute and relative momentum are positive, since long-only momentum effect results are highly regime dependent. In order to increase performance, the simple strategy is expanded to capture both relative and absolute momentum creating an equity long short portfolio.
Various extensions to the simple strategies shown above have been suggested. For example we can deploy mean-variance optimisation to re-weight our assets to minimise the risk given return. Moreover, we can diversify the strategy by restricting the weights to different asset classes and risk factors as well as adding various risk management practices to decrease leverage during heightened volatility periods. Furthermore, taking into account the cyclicality and idiosyncratic momentum of various sub-indices to Faber’s original asset classes produces even stronger improvements to risk-adjusted returns. Unfortunately, cross-sectional strategies use high number of stocks resulting in high trading costs. Luckily, it has been found that using sectors and indices instead of individual stocks still earns similar returns while having lower trading costs – investor can employ equity sector momentum, momentum asset allocation strategy or industry momentum strategies.
Numerous empirical studies report on benefits of extending strategy across asset classes (see Rouwenhorst 1998, Blake 1999, Griffin, Ji, and Martin 2003, Gorton, Hayashi, and Rouwenhorst 2008, Asness, Moskowitz, and Pedersen 2009). For example, including commodities (commodity momentum trading strategy) in this strategy can achieve better diversification and protection from inflation while having equity like returns (Erb and Harvey, 2006). Foreign exchange is another asset class with published effect – currency momentum factor effect. Okunev and White (2003) find the well-documented profitability of this strategy to hold for currencies throughout the 1980s and the 1990s. Contrary to already mentioned asset classes, bond returns have generally not displayed momentum. However, some later evidence suggests that assorting bonds with volatility adjusted returns leads to observation of momentum. Using 68,914 individual investment-grade and high-yield bonds, Jostova et al. (2013) find strong evidence of strategy’s profitability in US corporate bonds over the period from 1973 to 2008. Past six-month winners outperform past six-month losers by 61 basis points per month over a six-month holding period. Last but not least, momentum has been documented in mutual fund returns and in real estate with a cross-sectional strategy significantly reducing volatility and drawdown of a long only REIT fund – momentum in REITs.
An often cited benefit of momentum strategies is their sustainable performance attributed to a true anomaly rather than skewedness in the return probability distribution that is cited to be responsible for value and carry strategy. Reasons explaining this anomaly include analyst coverage, analyst forecast dispersion, illiquidity, price level, age, size, credit rating, return chasing and confirmation bias, market-to-book, turnover and others. It has been remarkably persistent through time despite the large amount of attention and arbitrage capital that could erode the momentum returns. Academic research suggests that the persistency of the excess returns is caused by deeply imbedded slow moving factors such as confirmation bias. This implies that this strategy is likely to remain effective in the foreseeable future.
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