Factor investing is an institutional quantitative investing methodology that is becoming more mainstream. It developed from academic studies that a few factors can explain stock market performance. From there, the factors became the drivers of market outperformance. Some factors include momentum, volatility, value, size, quality, and yield. At AllQuant, while we did not set out to pursue factor-based investing, our strategies are generally tilted toward momentum and volatility factors so we are going to focus on these two factors. We will talk about momentum in this post and we will cover the volatility factor in a follow-up post.
What Is Momentum?
Those who studied physics should have a good conceptual grasp of momentum. Momentum is a key feature of Newton's laws of motion. At the risk of over-simplifying, a stationary object tends to remain so. This is called inertia. However, an object in motion tends to stay in motion unless an opposite force like friction slows it down. This is called momentum.
In the capital markets, asset prices also exhibit momentum. Although this is not the same physical law governing physics, the law of crowd psychology imitates it. Hence, an asset whose price has been stagnant tends to remain so, until some event causes the price to rise which then tends to rise for some time until another event stops the price from rising. Momentum can also apply to falling prices as well.
How Do Institutions Harvest Momentum?
There are many ways to implement a momentum strategy but generally, institutions pursue a long-short market neutral strategy by buying stocks that have done well and selling stocks that have done poorly over some recent past period and they hold the positions over 3 to 12 months. After that, they repeat the process. This can be replicated across other asset classes as well.
How Strong Is The Momentum Factor?
On a historical basis, the momentum factor has been one of the strongest generators of excess returns. However, it doesn't mean that momentum wins all the time. The momentum factor has typically outperformed in a macro environment characterized by a long cycle in underlying market trends. This is logical since a continuation of the market trend means greater profits on the positions. On the other hand, if the market environment doesn't allow momentum to last, then momentum strategies will get whipsawed.
Over the recent decades, the momentum factor has outperformed all other factors. What about over a much longer time frame?
According to MSCI Research, from 1976 to 2016, the momentum factor delivered the second-highest annualized return, losing only to the value factor. However, it is worth noting that the value factor seems to have lost its effectiveness in more recent years while momentum continued to deliver.
What Are The Pitfalls Of Using Momentum?
Momentum strategies are notorious for occasional big crashes from a sudden change in market trends. It is even more drastic for a long-short momentum strategy because the two legs can reverse at the same time resulting in double losses. Short positions also can suffer from implementation constraints. Stocks may not be available to borrow or are insufficient in size. Even if the short position can be implemented, the stocks can be called back anytime, leaving the buy leg exposed to market risk.
How To Mitigate Risk?
If you wish to reduce the risk from shorting stocks, the easiest way is to only run long momentum strategies. However, that means you are exposed to market risk. So the usual market risk mitigating approaches can be used.
1) Diversify across stocks and asset classes
2) Use risk-based allocation for position sizing
3) Adopt volatility targeting
4) Apply filters to exit during a prolonged downtrend
Conclusion
The momentum factor is one of the oldest known investing factors. It has been empirically proven to work and it is still working today. However, it is notoriously volatile and can suffer from sudden crashes. Risk-mitigating measures can be taken when employing momentum strategies.
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