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.
Trend-following funds and strategies were once extremely popular after the 2008/2009 crisis. They offered attractive performance, and diversification properties made them a nice addition to investor’s portfolios. Ten years later, “trend-following strategy” is not such a popular word. Strategies didn’t blow-up, but their performance was far from spectacular. What are the main reasons for that? Is it an increased correlation among markets? Are trend rules inefficient? An important recent academic study written by Babu, Hoffman, Levine, Ooi, Schroeder, and Stamelos (all from AQR Capital Management) analyzes trend-following performance for each decade in the last 140 years and uses three distinct factors: the magnitude of market moves, the efficacy of trend-following strategies at capturing profitability from market moves, and the degree of diversification across trends in a trend-following portfolio. They show that it’s the first factor (a lack of large risk-adjusted market moves, positive or negative) that had the biggest impact in the last decade. This suggests that trend-following strategies should be able to deliver better performance in the future if the size of the market moves reverts to levels more consistent with the long-term historical distribution of returns…
Authors: Babu, Hoffman, Levine, Ooi, Schroeder, and Stamelos
Title: You Can’t Always Trend When You Want
Academic literature recognizes a large set of indicators or factors that are connected with the various assets. These indicators can be utilized in a variety of trading strategies, which means that such indicators are popular among practitioners who seek to invest their funds. Usually, the indicators are connected with some evaluation period.
This paper aims to show some possible approaches to find the optimal evaluation periods of indicators. This is a key question among practitioners and therefore we see it as crucial to shed a light on this topic. Although we are focused on momentum strategies, the information in this paper is widely applicable also in the construction of any other trading strategy where the investor has to decide indicator’s period…
Everyone who lived during the 2007 and 2009 crisis knows what the biggest weakness of the equity momentum strategy was. It was right during the spring of 2009 when the financial markets were on its inflection point when the momentum strategy crashed. Right after that inflection point, stocks which were the biggest losers during the previous year performed exceptionally well and caused strong under-performance of classical long-short momentum strategy. How can we prevent this situation from happening again? That’s the topic of our favorite new recent study written by Matthias Hanauer and Steffen Windmueller. They analyze three momentum risk management techniques – idiosyncratic momentum, constant volatility-scaling, and dynamic scaling, to find the remedy for momentum crashes. It’s our recommended read for this week for equity long-short managers …
Authors: Matthias Hanauer and Steffen Windmueller
Title: Enhanced Momentum Strategies
What is the impact of volatility (and changes in volatility) on popular Currency Momentum and Currency Carry strategies? That’s the topic of recent academic study written by Duc Hong Hoang, which decomposes foreign exchange volatility into two components, namely, secular (long-term) and transitory or mean-reverting (short-term) components. Long term component captures business cycle effects, while short term volatility usually represents funding tightness or shocks. Carry trade strategy is linked (and therefore partially predictable) to long-run volatility while momentum reacts mainly to short-run risks.
Title: Long Run and Short Run Risk Premium in Currency Market
We are continuing in our short series of articles about calendar / seasonal trading. The main focus of this paper is to show that the well-working calendar / seasonal anomalies can be refined. The aim is to find the right factors and find a way how to combine them in a search for profit from the practitioner’s point of view. Based on our previous research, calendar anomalies are profitable, but there is a possible way how to enhance their performance. This can be done by employing momentum strategies. By assigning a weight to assets from a diversified set according to their momentum value, it is possible to find a profitable asset during various global market conditions. Moreover, a trend factor is used to ensure that when market conditions are not favorable, the strategy will not trade. Such addition is a typical approach used for reducing maximal draw-downs. Finally, since this paper is written from the practitioner’s point of view, we are assuming some model transaction costs and examine the strategy in their presence.
Financial academics have described so many equity factors that the whole universe of them is sometimes called “factor zoo”. Therefore, it is no surprise that there is a quest within an academic community to bring some order into this chaos. An interesting research paper written by Favilukis and Zhang suggests explaining a lot of equity factors with momentum anomaly. They show that very often, up to 50% of the equity factor returns can be linked to returns of momentum strategy. This link is especially prevalent in short legs of equity factors.
Authors: Favilukis, Zhang
Title: One Anomaly to Explain Them All