Momentum Investing

Do investors underestimate the adverse import of large left tails for future stock returns? In their November 2017 paper entitled “Left-Tail Momentum: Limited Attention of Individual Investors and Expected Equity Returns”, Yigit Atilgan, Turan Bali, Ozgur Demirtas and Doruk Gunaydin investigate the relationship between left-tail risk and next-month returns for U.S. and international stocks. They measure left-tail risk at the end of each month via either of:

• Value-at-risk (VaR) – daily return of a stock at the first (VAR1) or fifth (VAR5) percentile of its returns over the past one year (250 trading days).
• Expected shortfall – average daily return of a stock for the bottom 1% (ES1) or bottom 5% (ES5) of its returns over the past year (250 trading days).

They then sort stocks into tenths (deciles) based on left-tail risk and examine variation in next-month average gross returns across deciles. Using daily prices and monthly firm characteristics and risk factors for U.S. stocks with month-end prices at least $5 during January 1962 through December 2014, they find that: Keep Reading

Do firms that acquire patents in similar technologies persistently perform similarly? In the October 2017 draft of their paper entitled “Technology and Return Predictability”, Jiaping Qiu, Jin Wang and Yi Zhou examine monthly performance persistence of stocks grouped by similarity in recent firm patent activity. Specifically, they:

1. Record the patent activity of each firm by patent class over the most recent three calendar years.
2. Quantify similarity of this patent activity for each pair of firms.
3. Segregate firms into innovation groups based on patent activity similarity (top fifth of quantified similarities).
4. For each month during the next calendar year:
   • Rank stocks into fifths (quintiles) based on average prior-month, similarity-weighted return of their respective groups.
   • Form a hedge portfolio that is long (short) the equal-weighted or value-weighted stocks in the highest (lowest) return quintile.

They focus on gross average monthly return and stock return factor model alphas of the hedge portfolio as evidence of firm innovation group performance persistence. Using firm patent information by technology class during 1968 through 2010, and monthly stock data, quarterly institutional holdings and analyst coverage for a broad sample of U.S. stocks priced greater than $1 during 1968 through 2011, they find that:

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Do strongly accelerating firm earnings identify future outperforming stocks? In the October 2017 revision of their paper entitled “Earnings Acceleration and Stock Returns”, Shuoyuan He and Ganapathi Narayanamoorthy investigate the power of earnings acceleration (quarter-over-quarter change in earnings growth, which is year-over-year change in quarterly earnings) to predict abnormal stock returns. They test a hedged trading strategy that long (short) the equal-weighted tenth, or decile, of stocks with the highest (lowest) earnings acceleration for two holding intervals: (1) starting two days after earnings announcement and ending on day 30; and, (2) starting two days after earnings announcement and ending one day after the next quarterly earnings announcement. They allocate new earnings accelerations to deciles based on the prior-quarter distribution of values of earnings acceleration. They define abnormal return as that in excess of the capitalization-weighted market return. Using quarterly firm characteristics and earnings data and daily returns for a broad sample of U.S. stocks, excluding financial and utility stocks, during January 1972 through December 2015, they find that: Keep Reading

What makes momentum investing tick? In their September 2017 paper entitled “Understanding the Momentum Risk Premium: An In-Depth Journey Through Trend-Following Strategies”, Paul Jusselin, Edmond Lezmi, Hassan Malongo, Côme Masselin, Thierry Roncalli and Tung-Lam Dao present a theoretical analysis of the momentum risk premium. They assume that asset prices generally exhibit geometric Brownian motion (randomness) with constant volatility, but with a time-varying trend. They examine momentum strategy performance based on this model and test some conclusions empirically on a multi-class set of asset indexes. Based on mathematical derivations and using monthly returns for a universe of four equity, four government bond, three interest rate, five currency and four commodity indexes during January 2000 through July 2017, they find that: Keep Reading

Is it better to build equity multifactor portfolios by holding distinct single-factor sub-portfolios, or by picking only stocks that satisfy multiple factor criteria? In their September 2017 paper entitled “Smart Beta Multi-Factor Construction Methodology: Mixing vs. Integrating”, Tzee-man Chow, Feifei Li and Yoseop Shim compare long-only multifactor portfolios constructed in two ways:

1. Integrated – each quarter, pick the 20% of stocks with the highest average standardized factor scores and weight by market capitalization.
2. Mixed – each quarter, hold an equal-weighted combination of single-factor portfolios, each comprised of the capitalization-weighted 20% of stocks with the highest expected returns for that factor. 

They consider five factors: value (book-to-market ratio), momentum (return from 12 months ago to one month ago), operating profitability, investment (asset growth) and low-beta. They reform factor portfolios annually for all except momentum and low-beta, which they reform quarterly. Using firm data required for factor calculations and associated stock returns for a broad sample of U.S. stocks during June 1968 through December 2016, they find that: Keep Reading

How efficiently do mutual funds capture factor premiums? In their April 2017 paper entitled “The Incredible Shrinking Factor Return”, Robert Arnott, Vitali Kalesnik and Lillian Wu investigate whether factor tilts employed by mutual fund managers deliver the alpha found in empirical research. They focus on four factors most widely used by mutual fund managers: market, size, value and momentum. They note that ideal long-short portfolios used to compute factor returns ignore costs associated with real-world implementation: trading costs and commissions, missed trades, illiquidity, management fees, borrowing costs for the short side and inability to short some stocks. Portfolio returns also ignore bias associated with data snooping in factor discovery and market adaptation to published research. They focus on U.S. long-only equity mutual funds, but also consider similar international funds. They apply a two-stage regression first to identify fund factor exposures and then to measure performance shortfalls per unit of factor exposure. Using data for 5,323 U.S. and 2,364 international live and dead long-only equity mutual funds during January 1990 through December 2016, they find that:

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Which equity factors have high and low expected returns? In their February 2017 paper entitled “Forecasting Factor and Smart Beta Returns (Hint: History Is Worse than Useless)”, Robert Arnott, Noah Beck and Vitali Kalesnik evaluate attractiveness of eight widely used stock factors. They measure alpha for each factor conventionally via a portfolio that is long (short) stocks with factor values having high (low) expected returns, reformed systematically. They compare factor alpha forecasting abilities of six models:

1. Factor return for the last five years.
2. Past return over the very long term (multiple decades), a conventionally used assumption.
3. Simple relative valuation (average valuation of long-side stocks divided by average valuation of short-side stocks), comparing current level to its past average.
4. Relative valuation with shrunk parameters to moderate forecasts by dampening overfitting to past data.
5. Relative valuation with shrunk parameters and variance reduction, further moderating Model 4 by halving its outputs.
6. Relative valuation with look-ahead full-sample calibration to assess limits of predictability. 

They employ simple benchmark forecasts of zero factor alphas. Using 24 years of specified stock data (January 1967 – December 1990) for model calibrations, about 20 years of data (January 1991 – October 2011) to generate forecasts and the balance of data (through December 2016) to complete forecast accuracy measurements, they find that: Keep Reading

Does transient factor popularity drive factor/smart beta portfolio performance by pushing valuations of associated stocks up and down? In their February 2016 paper entitled “How Can ‘Smart Beta’ Go Horribly Wrong?”, Robert Arnott, Noah Beck, Vitali Kalesnik and John West examine degrees to which factor hedge portfolio and stock factor tilt (smart beta) backtests are attractive due to:

1. Steady and clearly sustainable factor premiums; or,
2. Changes in factor relative valuations, measured as average price-to-book value ratio of stocks with high expected returns (factor portfolio long side) divided by average price-to-book ratio of stocks with low expected returns (factor portfolio short side). This ratio tends to increase (decrease) as investor assets move into (out of) factor portfolios.

They consider six long-short factor hedge portfolios: value, momentum, market capitalization (size), illiquidity, low beta and gross profitability. They also consider six smart beta portfolios, which they (mostly) require to sever the relationship between stock price and portfolio weight and to have low turnover, substantial market breadth, liquidity, capacity, transparency, ease of testing and low fees: equal weight, fundamental index, risk efficient, maximum diversification, low volatility and quality. Using specified annual and monthly factor measurement data and returns for a broad sample of U.S. stocks during January 1967 through September 2015, they find that: Keep Reading

Do broad (capitalization-weighted) stock market indexes exhibit factor tilts that may indicate concentrations in corresponding risks? In their August 2017 paper entitled “What’s in Your Benchmark? A Factor Analysis of Major Market Indexes”, Ananth Madhavan, Aleksander Sobczyk and Andrew Ang examine past and present long-only factor exposures of several popular market capitalization indexes. Their analysis involves (1) estimating the factor characteristics of each stock in a broad index; (2) aggregating the characteristics across all stocks in the index; and (3) matching aggregated characteristics to a mimicking portfolio of five indexes representing value, size, quality, momentum and low volatility styles, adjusted for estimated expense ratios. For broad U.S. stock indexes, the five long-only style indexes are:

• Value – MSCI USA Enhanced Value Index.
• Size –  MSCI USA Risk Weighted Index.
• Quality – MSCI USA Sector Neutral Quality Index.
• Momentum –  MSCI USA Momentum Index.
• Low Volatility – MSCI USA Minimum Volatility Index.

For broad international indexes, they use corresponding long-only MSCI World style indexes. Using quarterly stock and index data from the end of March 2002 through the end of March 2017, they find that: Keep Reading

Does global diversification improve smart beta (equity factor) investing strategies? In their September 2017 paper entitled “Diversification Strikes Again: Evidence from Global Equity Factors”, Jay Binstock, Engin Kose and Michele Mazzoleni examine effects of global diversification on equity factor hedge portfolios. They consider five factors:

1. High-Minus-low Value (HML) – book equity divided by market capitalization.
2. Small-Minus-Big Size (SMB) – market capitalization.
3. Winners-Minus-Losers Momentum (WML) – cumulative return from 12 months ago to one month ago.
4. Conservative-Minus-Aggressive Investment (CMA) – change in total assets.
5. Robust-Minus-Weak Operating Profitability (RMW) – total sales minus cost of goods sold, selling, general, and administrative expenses and interest, divided by total assets.

They reform each factor portfolio annually at the end of June by: (1) resetting market capitalizations, segregating firms into large (top 90%) and small (bottom 10%); (2) separately for large and small firms, constructing high (top 30% of factor values) minus low (bottom 30%) long-short sub-portfolios; and, (3) averaging returns for the two sub-portfolios to generate factor portfolio returns. They lag firm accounting data by at least six months between fiscal year end and portfolio formation date. They define eight global regions: U.S., Japan, Germany, UK, France, Canada, Other Europe and Asia Pacific excluding Japan. When measuring diversification effects, they consider relatedness of country markets and variation over time. Using the specified firm accounting data and monthly stock returns during October 1990 through February 2016, they find that: Keep Reading