Blog - Investing Notes
August 16, 2007 - Trading Friction
as a Momentum Killer
Are momentum trading strategies profitable after accounting for trading
costs? In their August 2007 draft paper entitled "Low-Cost
Momentum Strategies", Xiafei Li, Chris Brooks and Joëlle Miffre
analyze the impact of transaction costs on the profitability of momentum
strategies for UK stocks. They consider all combinations of 3-month,
6-month and 12 month ranking and holding periods. Using stock price
data for 3,520 UK companies and separately for the constituents of the
FTSE 100 index (large capitalization stock sample) and the Alternative
Investment Market (AIM - small capitalization stock sample) over the
period 1986-2005, they conclude that:
- Across all strategies, before trading costs, the portfolios
that are long past winners and short past losers earn an average monthly
return of 1.9%, ranging from 1.6% for the 3-3 strategy to 2.2% for
the 12-3 strategy. Momentum profits come mostly from the short positions,
with past losers (winners) producing an average monthly return of
-1.6% (0.32%). Momentum stocks, especially past losers, tend to have
relatively low price, market capitalization and trading volume.
- Average total round-trip trading friction based on quoted spread
is 6.7% (3.8%) for past losers (winners). These costs effectively
offset the above momentum portfolio returns.
- Past losers are more expensive to trade than past winners due to
the high cost of shorting stocks them (selling costs average 2.3 times
higher for past losers than for past winners).
- A low-cost momentum strategy that focuses on the past winners and
past losers with relatively low total transaction costs does
generate abnormal returns. Momentum portfolios that are long past
winners and short past losers with the 10%, 20% and 50% lowest total
transaction costs generate average net annual returns of 19.1%, 15.5%
and 12.6%, respectively. Among all such strategies, the 12-12-10%
(12-month ranking period, 12-month holding period, among 10% of stocks
with lowest transaction costs) is the most profitable with an average
27.7% net annual return.
The following chart, taken from the paper, shows the average estimated
effective half-spreads for buyer-initiated (Buy) and seller-initiated
(Sell) trades for three past winner portfolios, three past loser portfolios,
and for the average stock in the FTSE 100 and AIM indexes. Overall,
the chart shows that shorting of small capitalization past losers is
costly. Specifically:
- Selling small capitalization stocks (AIM) is more costly than selling
large capitalization stocks (FTSE 100), and more costly than buying
any size stock.
- Selling past winners is only a little more costly than buying past
winners.
- Selling past losers is much more costly than buying past losers.
Momentum strategies that ignore transaction costs tend not to outperform
because of the high transaction costs of selling past losers.
In summary, successful momentum trading may depend critically on
restricting consideration to stocks with the lowest total transaction
costs.
For related research, see Blog
Synthesis: Momentum Investing/Trading.
