Yet Another Study On The Wonders Of Momentum

Momentum is one of the oldest and most persistent anomalies in the financial literature. The tendency of positive or negative returns to persist for a time seems like a ridiculously simple predictor, but it works. There’s an ongoing debate about why it works, but the results in numerous tests speak loud and clear. Unlike many (most?) reported sources of alpha, the market-beating and risk-lowering results linked to momentum strategies appear to be immune to arbitrage. Assets dedicated to exploiting this risk factor keep rising, but momentum’s results continue to impress. That’s a high standard, and one that trips up most strategies. Momentum, however, seems to be an exception.

That’s rather amazing when you consider that this line of study is no spring chicken. Informally, it’s fair to say that investors have been exploiting momentum in various forms for as long as humans have been trading assets. Formally, the concept dates to at least 1937, when Alfred Cowles and Herbert Jones reviewed momentum in their paper “Some A Priori Probabilities in Stock Market Action.” In the 21st century, an inquiring reader can easily find hundreds of papers on the subject, most of them published in the wake of Jegadeesh and Titman’s seminal 1993 work: “Returns to Buying Winners and Selling Losers: Implications for Stock Market Efficiency,” which marks the launch of the modern age of momentum research.
And now there’s one more study to consider: “Absolute Momentum: A Simple Rule-Based Strategy and Universal Trend-Following Overlay,” by Gary Antonacci (Portfolio Management Consultants). If you’re familiar with the literature, you won’t find anything new here, but it’s worth a read anyway. Antonacci’s focus is on absolute momentum, which isn’t quite as topical in the literature as its cross-sectional counterpart. In any case, he does a fine job of summarizing the research and updating how the numbers stack up in a real-world setting with reference to alpha generated with a 12-month look-back strategy. We’ve seen comparable numbers before, but it’s as compelling as ever.
One section of Antonacci’s paper focuses on how a momentum-based strategy affects asset allocation and rebalancing. A test is applied to the standard 60% stocks/40% bond benchmark for the years 1974 through 2012. As you might expect at this point, adding momentum to the mix boosts performance and lowers risk. This is partly because of the limits of the conventional 60/40 from a risk-management perspective:

The regular 60-40 portfolio without momentum shows some reduction in volatility and drawdown compared to an investment solely in US stocks. However, the strong 0.92 correlation of the regular momentum 60-40 portfolio with the S&P 500 shows that the 60-40 portfolio has retained most of the market risk of stocks. Because stocks are much more volatile than bonds, stock market movement dominates the risk in a 60-40 portfolio. From a risk perspective, the regular 60/40 portfolio is, in fact, mainly an equity portfolio, since stock market variation explains nearly all the variation in performance of the regular 60-40 portfolio.

Antonacci goes on to note:

The traditional 60-40 portfolio offers little in the way of risk-reducing diversification,
even though it looks balanced from the perspective of dollars invested in each asset class. From
1900 through 2012, the probability of the 60-40 portfolio having a negative real return has been
35% in any one year, 20% over any 5 years, and 10% over any 10 years8. Adding a simple 12-
month absolute momentum overlay to the 60-40 portfolio may be all that is necessary to achieve market level returns with a more reasonable amount of downside risk.

Using momentum to enhance rebalancing has become a familiar field of study, in part because Mebane Faber brought so much attention to the subject in his widely read 2007 study “A Quantitative Approach to Tactical Asset Allocation.” Antonacci doesn’t break new ground in his paper, but he does a good job of reminding how and why momentum can play a productive role in enhancing rebalancing strategies. Overall, “adding a simple 12-month absolute momentum overlay to the 60-40 portfolio may be all that is necessary to achieve market level returns with a more reasonable amount of downside risk,” he writes. Translating his analysis into a graph, here’s how the historical record compares:

He adds that “the trend following, market-timing feature of absolute momentum may be more valuable now than in the past, when the world was less inter-connected, asset correlations were lower, and diversification alone was better able to reduce downside exposure.” Perhaps, then, momentum is a partial antidote to the portfolio challenges associated with the rising globalization of asset prices, as William Bernstein has discussed in some detail in his recent e-book: Skating Where the Puck Was: The Correlation Game in a Flat World .
Momentum, it seems, is one of the rare risk factors with features that elude so many other strategies: It’s persistent, conceptually straightforward, robust across asset classes, and relatively easy to implement. It’s hardly a silver bullet, but nothing else is either. Yes, all the usual caveats apply. One potential problem that can’t be overlooked is the potential for transaction costs to eat up any benefit, depending on the details. Nonetheless, momentum continues to warrant careful study.
The only mystery: Why are we still talking about this factor in glowing terms? We still don’t have a good answer to explain why this anomaly hasn’t been arbitraged away, or why it’s unlikely to meet an untimely demise anytime soon.