Doing Momentum with Style (ETFs)
Posted in Momentum Investing, Size Effect, Value Premium
July 23, 2010
“Beat the Market with Hot-Anomaly Switching?” concludes that “a trader who periodically switches to the hottest known anomaly based on a rolling window of past performance may be able to beat the market. Anomalies appear to have their own kind of momentum.” Does momentum therefore work for style-based exchange-traded funds (ETF)? To investigate, we apply a simple momentum strategy to the following six ETFs that cut across capitalization (large, medium and small) and value versus growth:
iShares Russell 1000 Value Index (IWD) – large capitalization value stocks.
iShares Russell 1000 Growth Index (IWF) – large capitalization growth stocks.
iShares Russell Midcap Value Index (IWS) – mid-capitalization value stocks.
iShares Russell Midcap Growth Index (IWP) – mid-capitalization growth stocks.
iShares Russell 2000 Value Index (IWN) – small capitalization value stocks.
iShares Russell 2000 Growth Index (IWO) – small capitalization growth stocks.
The simple (6-1) strategy allocates all funds each month to the one style ETF with the highest total return over the past six months. A six-month ranking period is intuitively large enough to gauge style momentum but small enough to react to changes in business conditions that might favor one style over others. Using monthly dividend-adjusted closing prices for the style ETFs and S&P Depository Receipts (SPY) over the period 8/01-6/10 (107 months, limited by data for IWS/IWP), we find that:
The following chart shows the distribution of style ETF winners based on past six-month total return over the entire sample period. The mid-capitalization value style comprises 32 of the 100 monthly winners (32%).
How does applying the 6-1 style momentum strategy translate into cumulative returns?
The next chart compares the cumulative values of $10,000 initial investments in each of the style ETFs, the net 6-1 style momentum strategy and SPY over the sample period. Calculations derive from the following assumptions for the 6-1 strategy:
- Reallocate at the close on the last trading day of each month (assume that total six-month past returns for the ETFs can be calculated just before the close).
- Trading (switching) friction is 0.25% of the balance whenever there is an ETF switch.
- Ignore any tax implications of trading.
At the assumed level of switching friction, the net style momentum strategy outperforms five of the six style ETFs (losing only to IWS). The style momentum strategy finishes first if the ETF switching friction is 0.06% of the balance or lower. It appears that the relative performance of the style momentum strategy may depend on the mix of bull and bear markets in the sample.
The net 6-1 style momentum strategy outperforms an equally weighted portfolio of the style ETFs (not shown), even ignoring rebalancing frictions for the latter.
How do average monthly returns, as alternative measures of strategy performance, compare?
The following table shows the average (arithmetic mean) monthly returns and standard deviations of monthly returns for SPY, each of the style ETFs and the 6-1 style momentum strategy (gross and net) over the sample period. Net style momentum has the third highest average monthly return (after IWS and IWN, mid-capitalization and small-capitalization value, respectively). Gross style momentum ties with IWS for the highest average monthly return.
Is the relative performance of the 6-1 style momentum strategy stable over time?
The final chart compares the net market-adjusted return for the 6-1 style momentum strategy (relative to SPY) by month over the sample period, along with a trend line. The trend line slopes downward, suggesting that strategy outperformance weakens over time. However, removing the single extreme positive excess return for April 2002 makes the trend approximately flat, so evidence of weakening is not compelling.
The very small sample size (about 18 independent six-month momentum ranking intervals) and potential non-normalities in ETF monthly return distributions limit confidence in the above results.
Including ETFs representing other asset classes (such as bonds, commodities, equity sectors and international stocks) may enhance results.
In summary, a simple style momentum strategy implemented with ETFs may perform well compared to the overall stock market and individual style ETFs.
