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 in equities), however there is large evidence documenting momentum 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 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, 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 momentum, however, it is desirable to be long only when both absolute and relative momentum are positive, since long-only momentum results are highly regime dependent. In order to increase performance, the simple momentum strategy is expanded to capture both relative and absolute momentum creating a 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 momentum returns while having lower trading costs.
Numerous empirical studies report on benefits of extending momentum 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 in a momentum 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 momentum effects. Okunev and White (2003) find the well-documented profitability of momentum strategies with equities 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 momentum 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 real estate with a cross-sectional momentum buy/sell strategy significantly reducing volatility and drawdown of a long only REIT fund.
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 the momentum 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.
In a game of poker, it is usually said that when you do not know who the patsy is, you’re the patsy. The world of finance is not different. It is good to know who your counterparties are and which investors/traders drive the return of anomalies you focus on. We discussed that a few months ago in a short blog article called “Which Investors Drive Factor Returns?“. Different sets of investors and their approaches drive different anomalies, and we have one more paper that helps uncover the motivation of investors and traders for trading and their impact on anomaly returns.
India is a big emerging market, actually the second biggest after China. We primarily look at developed markets, mostly the U.S. and Europe, and from Emerging Markets, China at most, and we are aware that we neglect this prospective country. We would like to correct this notion and give attention to a country that is (along with China) being cited as a new potential rising superpower and already looking to take the lead of Emerging Markets (EM) countries. Today, we would like to review the paper that analyzes the performance of main equity factors (with an emphasis on the Quality factor) and is a good starting point to understand the specifics of factor investing strategies in India.
Sector/industry picking or country picking can be a profitable trading style but is usually much more challenging than it seems at first sight. Building a good trading model requires a lot of research and dedication. Unfortunately, due to the limited numbers of industries and countries, sorting them on aggregate characteristics can wash out important cross-sectional variations in the characteristics and lead to concentrated portfolios prone to noisier realized returns.
In their fresh Dimensional Fund Advisors research piece, Dong, Huang, and Medhat (2023) touch on the question of whether investors should systematically emphasize certain industries or countries to increase expected returns. Their overhead view provides new insights and sums that investors will likely be better off pursuing premiums in the larger cross-section of individual securities and maintaining broad diversification across the smaller cross-sections of industries and countries.
Bearish trends or deep corrections in international equity markets starting in 2022 and rising interest rates worldwide brought investors’ attention back to not only once-proclaimed dead factor investing. From long-run and short run, during different market cycles, different factors behave differently. What’s fortunate is that it is pretty predictable to some extent. Andrew Ang, Head of Factor Investing Strategies at BlackRock, in his Trends and Cycles of Style Factors in the 20th and 21st Centuries (2022), used Hodrick-Prescott (HP) filter and spectral analysis to investigate different models to draw some general conclusions on most-widely used factors. We will take a look at a few of quite the most interesting ones of them.
Skewness is one of the less-known but practical measures from statistics that can be used in trading. It is defined as a measure of the asymmetry of the probability distribution of a random variable around its mean. The goal of this analysis is to explore the commodity skewness trading strategy and perform the battery of robustness tests to see how sensitivity analysis changes overall results regarding performance, volatility, and Sharpe ratios.
The commodity momentum strategy is a crucial driving force behind Commodity Trading Advisor (CTA) strategies, as it capitalizes on the persistence of price trends in various commodity markets. By identifying and exploiting these trends, CTAs can achieve robust returns and diversification benefits. In their new paper, John Hua FAN and Xiao QIAO (February 2023) present their perspective and understanding of cross-country and cross-sector influences on the behavior of commodity momentum beyond established commodity fundamentals focusing on U.S. and China markets.