Some portfolios you consistently ended up with higher returns, implying that there was something about the market, something systematic, that was driving them. What are these factors? Factors, Intro
Systematically accounting for excess returns became an academic sack race. Factors, The Famous 5
While fundamental factors play a role in explaining excess returns, technical factors cannot be ignored either. Thus, Momentum. While the market can be sliced-and-diced in many different ways, here’s a simple way to go about it: The All Star Backtest.
Most momentum strategies use a skip month. What happens if you don’t? And what happens if you skip two? Does it make sense to rebalance weekly?
Momentum portfolios are extremely volatile. But, is it possible that a portfolio of less volatile stocks out-perform the market? Ergo, the Low Volatility Anomaly.
Turns out, you can boost returns of a low-volatility strategy by adding a bit of momentum. VOLxMOM.
Both Factor Rotation (buying what worked best in the past) and Multi-Factor (buying all factors) work. As long as you stick with it.
Our previous post on Momentum highlighted the inherent cliff-risk in the “buy-high, sell-higher” strategy. But even before Fama French published their 3-Factor paper, researchers had found that the “high risk = high reward” relationship is quite fragile. In 1972, Haugen, Robert A., and A. James Heins, studying the period from 1926 to 1971, came out with a working paper – On the Evidence Supporting the Existence of Risk Premiums in the Capital Market (ssrn) – that concluded that over the long run stock portfolios with lesser variance in monthly returns have experienced greater average returns than their ‘riskier’ counterparts (wikipedia).
Basically, a portfolio of low-volatility stocks will out-perform the market. More returns for less risk.
What Explains the Anomaly?
There are two main trains of thought on why this anomaly persists.
It is difficult to short high-beta stocks and buy low-beta stocks. Because, if it were easy, one could construct a zero-beta portfolio with positive expected returns… and this anomaly would vanish.
Stocks of companies with predictable earnings exhibit low-volatility. So, low-volatility is essentially high-quality – a known investment factor.
Historical Performance
While low-volatility has out-performed market indices, it is magic wand that makes drawdowns disappear.
India
US
Risks
The biggest risk in a portfolio of low-volatility stocks is that a large proportion of it could be held by weak hands – investors who are drawn to it primarily because of its low-volatility. And when faced with a drawdown that is steeper than historical experience, they can simultaneously head for the exits, resulting in a cascading drop in price. The triggers could be a missed earnings estimate, an industrial accident, etc. While momentum investors are used to being routinely hit in the head, a small shove can push low-volatility investors down a cliff.
Portfolio Construction
A portfolio of low-volatility stocks vs. a low-volatility portfolio of stocks.
While initial research focused on stocks that had low-volatility, a collection of low-volatility stocks can result in a portfolio with high-volatility if the correlations among them are high. To illustrate, consider two low-volatility stocks who’s volatility varies through time like this:
If you put them in the same portfolio, what happens to the portfolio volatility?
Now, what if you picked two stocks whose volatility were inversely correlate? In theory, you can mix to high-volatility stocks and get a low-volatility portfolio.
A Min-Vol portfolio tries to optimize the overall portfolio volatility. A completely different approach to having a portfolio of Low-Vol stocks. In the US, there are two large ETFs that track these different approaches: USMV – the iShares Edge MSCI Min Vol USA ETF, and SPLV – the Invesco S&P 500 Low Volatility ETF.
It appears that Min-Vol has an edge over Low-Vol in most scenarios.
Conclusion
While Momentum of Min/Low Volatility can appear to be diametrically different strategies, there are ways to mix them up in the same portfolio to achieve a lower-volatility momentum or a higher-return-low-vol outcomes.
However, at the end of the day, retail investors will forever be at the mercy of market beta. So, irrespective of which flavor of jam you like, the kind of bread you eat makes the biggest difference!
Profit by investing in stocks that have hit their all time highs
We launched the All Star Portfolio last week along with our discussion on momentum strategies. It is a great way for investors new to momentum (or equity investing, in general) to follow along a systematic momentum portfolio. We like this particular strategy because:
Lower risk compared to other momentum strategies.
Go-to cash if there aren’t viable candidates.
A wide trailing stop-loss to exit outliers.
Works with top-300 stocks by market cap – doesn’t depend on small caps to drive performance.
Lower churn compared to other momentum strategies.
Historical Performance
We start from 2010 and rebalance monthly. Observe the drawdowns and the relative out-performance of the All Star.
The reason for the lower drawdowns is the ability of the strategy to stay in cash when things are bad. While we can take up to 25 positions, the slots are not always filled. An equal weighted portfolio (4% per slot) with only 5 positions will have 80% in cash.
Moreover, the per-position max loss during the time frame has been less 10% in a given month.
By keeping a trailing stop-loss of 15%, we ensure that only the true outliers are caught by it and not the run-of-the-mill corrections that are bound to happen.
In Trade Wars Are Class Wars: How Rising Inequality Distorts the Global Economy and Threatens International Peace (Amazon,) authors Matthew Klein and Michael Pettis argue that a handful of elites have captured the financial benefits of open global trade and finance. This has caused a global savings glut and a hunt for safe assets that has resulted in a series of boom-busts in American asset prices and an hollowing-out of its manufacturing base. These underlying income and wealth inequalities have manifested themselves as trade wars.
Excerpt:
Trade war is often presented as a conflict between countries. It is not: it is a conflict mainly between bankers and owners of financial assets on one side and ordinary households on the other—between the very rich and everyone else. Rising inequality has produced gluts of manufactured goods, job loss, and rising indebtedness. It is an economic and financial perversion of what global integration was supposed to achieve.
America’s openness to international trade and finance means that the rich in Europe, China, and the other major surplus economies can squeeze their workers and retirees in the confidence that they can always sell their wares, earn their profits, and park their savings in safe assets.
The world’s rich were able to benefit at the expense of the world’s workers and retirees because the interests of American financiers were complementary to the interests of Chinese and German industrialists. Both complemented the interests of the wealthiest throughout the world, even from the poorest countries.
The book is an easy read and anyone who is interested in understanding the current macro environment should read it.
The Fama French 5-Factors came in two installments. The first 3 were published in 1992 and the rest in 2014. They capture “fundamental” factors, i.e., factors that can be derived from looking at balance-sheet and income statements. In 1993, Jegadeesh and Titman published their ground-breaking work on momentum: Returns to Buying Winners and Selling Losers: Implications for Stock Market Efficiency (pdf)
Their paper singularly propelled momentum (or, trend-following) into the mainstream by giving it the academic vigor it lacked earlier. While its findings may not have been earth-shattering for most traders, most professional investors looked at momentum strategies as something that “traders” did and avoided them. But within a decade of the paper being published, momentum strategies were firmly established as a “legitimate” strategy that could be allocated to.
Basic Design
The J/T paper constructs a long-short portfolio by ranking stocks based on their prior 12 month returns (skipping the most recent month.) The top decile portfolio is called the “losers” decile and the bottom decile is called the “winners” decile. In each month, the strategy buys the winner portfolio and sells the loser portfolio. This is the classic 12_1 momentum, where 12 denotes the formation period and the 1 is the number of skip months.
The reason for the skip month is to account for the short-term reversal effect associated with momentum. Some researchers, like Fama and French, do 12_2 momentum, where the most recent 2 months are skipped. However, a more recent study by Medhat and Schmeling (2018) finds that once we discard the stocks with the lowest turnover, equity returns exhibit short-term momentum rather than short-term reversal. So, the short-term reversal effect may not be as prevalent as is usually thought and one could even go with a 12_0 momentum.
The French Momentum Library
Luckily for us, Ken French (of the Fama French fame) regularly updates factor statistics on his Tuck School of Business webpage.
While the momentum factor (MOM) has out-performed the market factor (MKT = rm – rf = Market risk premium), over the long term, it is not without its share of pain.
Long-only Momentum
As “retail” investors, we typically invest in long-only portfolios. This makes momentum investing an extremely gut-wrenching ride. One day, you might be thinking which Greek island you are going to buy and the next day you might be scrambling to pay rent.
Momentum strategies have been packaged as an ETF for retail investors in the US for a while now. PDP, the Invesco DWA Momentum ETF, and MTUM, the iShares MSCI USA Momentum Factor ETF, are the 800-pound gorillas in the room.
The differences in performance highlight the different ways momentum strategies can be implemented.
The Indian story is relatively new. A monthly-rebalance momentum strategy has delivered superior returns (although, with a massive dose of heartburn.)
Measures of Momentum
Once the J/T paper was out, academics got to work and systematically mapped out more than a dozen different ways to setup up momentum portfolios. The most common ones are:
12_2/12_1/12_0: These are the “original” momentum portfolios formed by only looking at absolute returns.
Relative: For each stock, create a distribution of relative returns over every other stock in the universe and use it to drive portfolio formation.
Acceleration: Rank stocks based on how well they have performed over the last 6-months vs. their preceding 6-month returns.
CAPM-α: Rank stocks based on their α over an index.
Sharpe ratio: Rank stocks based on their Sharpe ratios.
Idiosyncratic/Residual: Rank stocks based on what is left after fitting a Fama-French 5-factor model. i.e., whatever cannot be explained by the 5-factors.
52-week or All-time Highs: A portfolio of stocks who’s prices have hit either one-year of all-time highs.
These are further combined with some sort of risk management measure, like a stop-loss or a trend overlay. So, based on the universe of stocks, frequency of rebalancing, momentum measures and risk-management technique applied, there are hundreds of different “momentum” portfolios that can be created.
Conclusion
While momentum is now a well established investment strategy, it is not an easy one to be married to. Differences in portfolio construction: formation periods, skip months/weeks, stock universe, stop-losses, etc. have a big impact on overall performance.
While momentum definitively underlines the “no pain, no returns” maxim, in a twist of irony, academics discovered the “low-volatility” anomaly. What if, investors can take less pain for more returns? Stay tuned for our next Free Float!
Introducing the All Star Portfolio
Given the large number of choices in front of investors these days, we felt that there should be an on-ramp for those who want to just follow along a systematic strategy without committing their portfolios.
So, we built a momentum portfolio that is easy for first-time investors to follow along. We call this the All Star Portfolio and is based on stocks hitting their all-time-highs. Just subscribe to our substack and receive emails whenever there is a change in the portfolio.
