Momentum strategies are usually vulnerable to market reversals and high turnover. But there are ways to efficiently address these issues.
Momentum is often considered one of the most attractive − but also one of the riskiest − factors to exploit. This is partly due to the fact that most momentum strategies are vulnerable to market reversals, that can lead to severe losses for investors, as happened in 2009. Transaction costs can also pose a problem, as momentum strategies can imply relatively high turnover.
Over the past few years, however, momentum has established itself as an essential building block and a key component of multi-factor strategies. “Most investors want to include momentum in their factor based strategies these days,” says Simon Lansdorp, a portfolio manager from our Factor Investing Equities team.
Momentum is the tendency for recent winner stocks to continue to outperform, while recent loser stocks will continue to perform poorly. It is one of the strongest anomalies known to exist in equity markets around the world.
Renewed interest from investors in momentum is largely due to the fact that momentum strategies have had a great run, in part thanks to the general upward trend seen in major stocks markets. But recent good performance is not the only reason for their success.
Momentum acts as a great diversifier in a factor premium equity portfolio because of its low correlation with other factors, such as low volatility. In fact, it can even be negatively correlated with value. Therefore, adding momentum could improve the expected return of a factor portfolio without increasing its expected risk.
Momentum is a great diversifier in a factor equity portfolio
At Robeco, we’ve been researching and implementing momentum ever since we started building stock selection models in the 1990s, and our first fully quant equity portfolio introduced in 2002 profited from the momentum effect. Based on this long experience, we launched our unique active momentum strategy in September 2012, and we will continue to improve the way we exploit the momentum factor.
Since it was launched five years ago, this strategy has proved capable of delivering outperformance relatively consistently over time, even during rough patches in the markets. From September 2012 to January 2018, Our QI Global Momentum fund returned on average 15% per year, gross of fees, or 2.2 percentage points more than the MSCI All Country World index, with only slightly higher volatility resulting in a superior Sharpe ratio. On a quarterly basis, the strategy achieved positive absolute returns in 15 of the last 21 quarter, gross of fees. Moreover, the strategy managed to outperform the benchmark in 13 of the last 21 quarters.
That’s because instead of looking at conventional price momentum, our strategy focuses on stock-specific momentum, also referred to as ‘residual’ or ‘idiosyncratic’ momentum. Using residual momentum enables us to considerably reduce the general market reversal risk which plagues conventional momentum strategies.
Moreover, while conventional momentum can be explained by the fact that investors tend to both overreact and underreact to news, our research shows residual momentum is more a function of investor underreaction. “This is an extremely important point,” says Simon Lansdorp, “in particular at times when investors keep wondering how long the current bull market may last.”
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