What is momentum?
Momentum is a premier anomaly, which is prevalent across
different asset classes across the globe for a long period.
Momentum is the tendency of investments to persist in their
performance. Investments that have done well will continue to do well, while
those that have done poorly will continue to do poorly.
Momentum in the stock market is like Newton's third law of
motion. Stocks that are going up will keep going up, and stocks that are going
down will keep going down.
There are two types of momentum
- Absolute momentum
- Relative momentum
Absolute momentum: -
Absolute momentum looks
only for historical data (time series) of the financial asset or stock.
Let’s suppose if we are
looking for S&P 500 index or Nifty 50 index. We check the historical
performance like last one-year return and if it is positive then we can say
that it is in upward momentum and if it is negative then we can say that it is
in downward momentum. So, here we are not looking for any other type of asset
to compare the performance of the underlying asset. Absolute momentum reduces
the volatility and increases the risk-adjusted return.
Relative momentum: -
In this momentum, we
compare momentum among the assets or securities and decide based on their
relative performance.
Let’s say there are two stocks. A and B, A increased from
100 to 200 in a year, and B increased from 50 to 75 in a year. So here A gave
100% return and B gave 50% return. So, in the relative term, we use stock A and
discard stock B because stock B has relatively lower momentum.
Dual momentum: -
It is a combination of both
the momentums. Here what we are doing is first we compare the asset’s relative
performance for the given look back period and select the best performing asset
for that period.
Let’s say we are using the Nifty 50 index and 10 Year G-Sec
bond indices. So, for the selected look back period, which is the last 12-month
return while ignoring immediately preceding month. We compare these assets, and
based on the relative performance we select one asset and hold it for the given
holding period (1 month in our case). After one month we will do the same
exercise once again and select the asset based on its past performance.
Here we are getting the best of two worlds. It reduces the
volatility at the same time increases the risk-adjusted return.
Quantitative method to implement momentum strategy
Factors need to be considered while using a momentum
strategy
- Stocks universe and stocks weight
- Look back period
- Holding period (Portfolio rebalancing)
- Momentum quality (Path)
- Seasonality (Window dressing and Tax adjustment period)
Stocks universe and stock weight: -
Larger the
stock universe better the return for relative momentum, and also from the given
stock universe, how many stocks need to be selected that is also important. But
the problem with the larger stock universe is liquidity and size. You need to
consider those factors before selecting the stocks universe.
Look back period: -
Various studies have been
conducted across the globe for various asset classes and the best Look back
period is 12 months ignoring the last one month (to avoid near term noise).
Holding period: -
It is also associated with
portfolio rebalancing. Lower the holding period better is the return. But we
need to consider transaction costs while considering a shorter holding period.
Generally, once you formed the portfolio using momentum, its momentum will
remain for the next 1-6 months. So, for aggressive portfolio rebalancing
frequency should be a month and for a moderate portfolio, rebalancing should be
3 months.
Momentum quality: -
It is also known as path.
How does a particular stock reach higher decide the quality of the momentum?
There are two stocks A and B. A raised from 100 to 150 in a year and Stock B raised
200 to 300 in a year. Both have the same momentum, but stock A is up 60% of the
time during the past one year and stock B is up only 40% of the time to reach
the same level. So, in this case, stock A is higher quality momentum compared
to B. You can use various measures for the quality of the momentum like the volatility
of the stocks, lower the volatility higher is the quality.
Seasonality:-
It has been seen that quarter-end
month like March, June, September & December are the months where you will
get maximum momentum return because during these months active portfolio
managers have to show their holding to investors and they don’t want to show
looser in their portfolio (I am not explaining this phenomenon in detail here).
Also, the tax adjustment period is March, people tend to sell their loss-making
stocks during this period to get taxation benefit and they are buying winners
during this period. (Seasonality I haven’t explained in detail because it is
difficult to implement and also an exact effect of this parameter on momentum
result is still not confirmed significantly)
Few points to consider before using a momentum
strategy
- Equal weight and value weight of the selected stocks. From my back testing equal weight is giving good results.
- There might be a time when the momentum strategy underperforms compared to broad market indices for consecutive years.
- If you want to reduce downside risk you can combine momentum with value strategy, which will help you to reduce consecutive drawdown years.
- Also, you can combine momentum with trend following, which will restrict downside but at the same time reduce a little bit of return.
