For today's post and the next few I'll be going back to my favorite topic, quant investing. In this post, I want to explore pure momentum quant portfolios and, in particular, ways to make pure momentum investing tolerable and implementable to more investors.
Note: for a refresher on momentum and its power (arguably the most powerful factor in investing) see this great paper from AQR.
You may have noticed that none of the quant portfolios that I have presented on the blog are pure momentum strategies. Only two strategies, trending value and microcap trending value, use momentum to pick stocks at all - in combination with value. The rest of the quant strategies are pure value strategies. Why? Well, I pick my strategies on risk-adjusted returns, Sharpe and Sortino ratios. No pure momentum strategies have made the list of top strategies based on risk-adjusted returns in O'Shaughnessy's What Works On Wall Street (table 28.3 page 625 in the 4th edition for your reference). Pure momentum hasn't made the list of top strategies because it suffers from periodic momentum crashes which lead to large drawdowns. So, why even consider pure momentum? Most importantly for me is because it tends to be uncorrelated with pure value and can add value as a quant portfolio diversifier. Behaviorally, it can also help to stay in the game when value investing is out of favor as can happen for long periods of time. Do the late 1990s ring any bells? Finally, there are ways to mitigate some of the largest swings in pure momentum portfolios.
First, let's construct a simple pure momentum portfolio and look at the portfolio statistics. As usual, I'm using Portfolio123 for my portfolio constructions and backtests (these are more complicated portfolio simulations and not just simple stock screens). Let's take the S&P 500 index, sort the stocks by 52-week momentum (1-yr return), invest in the top 25 stocks equally weighted and re-balance the portfolio every month. Here are the results from the beginning of 1999 through the close on November 11, 2016.
Can you see the issues with pure momentum now? We get significant market-beating returns (8.75% CAGR vs. about 5% for the overall index) but with very large drawdowns which lead to low risk-adjusted returns (Sharpe of only 0.42). Most investors would not stick with such a strategy. Also, notice the high turnover of this strategy. Almost the entire portfolio turns over every month making it harder and more costly to implement. Now that we have a baseline, let's look at making some improvements.
Let's try and mitigate the large drawdowns first. We know stocks perform the worst and have the largest drawdowns during economic recessions. And we've already looked at a way to using economic indicators to improve risk-adjusted returns. So, let's use the SPY-UI combo indicator and apply it to the pure momentum portfolio above. This indicator is effective in quant portfolios. Below are the results.
That sure helped. Returns increased significantly, from 8.75% to 12.5% annually, and drawdowns dropped from -63% to much more tolerable -35%. Accordingly, Sharpe ratio also increases almost 50% to 0.63. Also, notice the lower correlation to the index. That's pretty darn good and it gives you an implementable and tolerable pure momentum strategy. Turnover is still quite high, though. There is one more set of tweaks we can make to improve things a bit more. We're going to limit the universe to Market Leading stocks. This is another O'Shaughnessy concept which I first discussed here. Market leaders are
…defined as non-utility stocks in the large stock universe (market cap > average) with shares outstanding greater than average, cash flow greater than average, sales greater than 1.5 times the average.
I think of this as a kind of momentum as well. Large, successful, liquid stocks. To reduce turnover we can also hold on to winners and not sell them until momentum starts to flag. And to make sure it doesn't flag too much we'll check once a week instead of every month. Finally, let's pull out the complete bag of tweaks, we'll switch to 6-month momentum since it tends to perform slightly better than 1-year momentum, we'll concentrate the portfolio even more and limit it to the top 10 holdings and give the re-balance tolerance wide berth at 30%. Results for this modified pure momentum portfolio are below.
Not too shabby. Higher returns, equivalent drawdowns, much lower turnover and a higher sharpe ratio. Also, much lower correlation to the index. I would only use 10 holdings if this strategy were part of a larger quant portfolio. As a stand-alone strategy I would probably stick with 25 stocks.
There you go. While pure momentum strategies can be quite effective they can be gut wrenching at the same time. Fortunately, with some tweaks investors can make these strategies tolerable and worthy of inclusion in a portfolio. In a future post we'll look at what I think is the biggest value in adding pure momentum to your quant arsenal, its diversification benefits, especially with respect to value strategies.