Advanced Investments:

Lecture 5
Prof. Andrea Buraschi
 Outline

 Momentum: some empirical evidence

 Out of sample evidence
 Explanations
 Asset allocation benefits
 Implementation issues
 Momentum is the phenomenon that stocks
Domande per la discussione

which have performed well in the past relative to

other stocks (winners) continue to perform well
in the future, and stocks that have performed
relatively poorly (losers) continue to perform
poorly.
 Why is Momentum Attractive?
• It has positive excess returns versus the relevant market
benchmarks—greater than the excess returns of size or value
(Fama-French factors)

• Its excess return to the market is negatively correlated with value’s

excess return

• Combining momentum with value can lead to a better portfolio

(more return with lower volatility)
 Why is Momentum a New Style?

• It is pervasive across all equity markets

• Small and large cap
• Industries and sectors
• Domestic and international
• Other asset classes

• It is not subsumed by existing styles

• It is neither value nor growth

Academic Discovery
Historical Evidence
Fama-French Regressions (1927-2010)
Is Momentum a Fourth Factor?
Risk or Anomaly?
Value beats S&P500: Arbitrage or Risk Premium?

Value

S&P500
When market goes down, all value stocks go down (more
than the market): it is a non-diversifiable risk!

Value Effect =
Premio del Rischio

S&P500

Value
 Momentum is Widely Researched

 304 papers published on momentum since discovery 157 papers

published in last 5 years (ISI Web of Knowledge)

 40 papers published in last 5 years in the Journal of Finance (15),

Journal of Financial Economics (16) and Review of Financial
Studies (9)

 395 working papers on momentum in last 3 years (source: SSRN

FEN)
Past Return Predictability over Horizons
Out of Sample Evidence
 Out of Sample Evidence: Signals

• Small cap and large cap stocks

• Industry momentum
• Corporate bond momentum
• Emerging markets momentum (all asset classes)
• Earnings momentum
• Consistency momentum
• Volume-weighted momentum
• Across stock momentum
• Customer-supplier momentum
 Why does momentum work?

• Behavioral (frictional) explanations:

• Slow adjustment to news & positive feedback, Disposition
effect

• Risk factor (rational) explanations:

• Momentum stocks move together, which may denote a
common factor (just like value)
• Momentum, like value, is highly correlated across asset
classes and markets

• Not an explanation: Data mining

 Explanations of Momentum
1. Disposition effect (Grinblatt and Han, 2005; Frazzini 2006) Evidence shows that individuals have low propensity
to sell those stock on which they have a capital loss (they act based on prior/private information and believe
that the market is wrong). This may have an equilibrium implications. These stocks tend to be overpriced with
respect to fundamentals. Thus, they will have lower returns in the future. The opposite holds true for those
stocks with capital gains.

Disposition: Odean (1998) shows that stocks that were up in value were 60% more likely to be sold than stocks
that were down.

Grinblatt and Han (2005) present a relatively simple theory in which momentum is driven by the disposition
effect. Intuitively, if disposition-prone investors are holding a stock for which good news is revealed, they will sell
their shares as prices rise (as the disposition effect predicts), decreasing any upward pressure on the stock price.
Similarly, if disposition-prone investors are holding a stock for which bad news is revealed, they will hold their
shares rather than sell on the news, again decreasing any downward pressure on the stock price. If any rational
investors trading against the disposition-prone investors do not fully adjust their demands for stocks to account
for the disposition bias, prices will take a relatively long time to converge to equilibrium levels following large
shocks. One implication of this theory is that the level of unrealized gains or losses among disposition-prone
investors is a sufficient statistic for future returns. Past returns might predict future returns because they are a
noisy proxy for unrealized gains or losses.

Theoretical explanations of the observed “disposition” effect.

a) Disposition effect often explained on the basis of “Prospect Theory”; other explanations: “Mental
Accounting”, and “Regret”.
2. Window Dressing: At the end of the quarter (year) nobody wants to show to
have the “wrong” stocks. Poor perfoming stocks are sold; the contrary occurs
about stocks that did well in the past (this is a pure behavioral explanation).

3. Slow Moving Capital. Arbitrage requires capital; capital flows slowly from
equilibrium A to equilibrium B. In this process there is the formation of trends.
Momentum is the implication of these trends (consistent with dynamics models
of models with “frictions”)
CTA funds (AHL, Winton, Bluetrend) try to exploit these effects.
Momentum’s Risks
Performance (1948:01-2006:12)
Statistics (01.1948-12.2006)

Daniel and Moskowitz, Momentum Crashes, Working Paper, 2013

Momentum during the last Financial Crisis
Momentum during the dot com bubble
Momentum during the Great Depression
What are the reasons for the poor performance?
winner Loser

Daniel and Moskowitz, Momentum Crashes, Working Paper, 2013

What are the reasons for the poor performance?

 Asymmetric beta exposure between long leg and short leg after turmoil
period. The widening beta differences between winners and losers could
be the explanation of dramatic crash on momentum once the market
started its recovery in March 2009. In the sense of the Merton (1990)
model, loser stocks were effectively an out-of-the-money option on the
underlying firm value.

 Unconventional Monetary Policy. In late November 2008, the Federal

Reserve started buying $600 billion in mortgage-backed securities, bank
debt and Treasury notes. At that time loser stocks were financials (Citi,
Bank of America, Goldman and Morgan Stanley) and others like General
Motors. Government bailouts put a floor underneath the prices of these
stocks and they consequently skyrocketed. During the Great Depression
policy makers also had great influence on asset prices.
Risk-Managed Approach to Improve Momentum

 Daniel and Moskowitz (2014)  An implementable dynamic momentum

strategy based on forecasts of each momentum strategy’s mean and
variance generates an unconditional Sharpe ratio approximately double
that of the static momentum strategy.

 Barroso and Santa-Clara (2014)  The weight of Momentum Portfolio is

inversely proportional to expected realized volatility. The goal is to keep
the estimated annualized volatility constant.
Risk-Managed Approach to Improve Momentum

Daniel and Moskowitz, Momentum Crashes, Working Paper, 2013

 Risk-Managed Momentum

 Following the procedure proposed by Barroso and Santa-Clara (2014) we

implement a risk-managed momentum and winner portfolio.

1. Download daily data for Momentum portfolios from French website

http://mba.tuck.dartmouth.edu/pages/faculty/ken.french/data_library.html
2. Using previous 6 months momentum (WML) daily returns forecast the variance
at time t using the formula

3. Scale the return at time t for the momentum portfolio using the estimate of the
variance for time t.

4. Apply the same procedure for the winning portfolio.

Risk-Managed Performance
Most Recent Findings
on
Momentum
 Recent Literature

 RISK-MANAGED APPROACH
 Barroso and Santa-Clara, «Momentum has its moments», Journal of Financial
Economics, 2014.
Idea: Rescaling momentum portfolio by an estimate of future volatility, the
Sharpe Ratio increases in all countries.

 Daniel and Moskowitz, “Momentum Crashes”, 2013.

Idea: Dig into Momentum crashes to try to understand these rare but turbulent
times. They find that these crashes typically occur after a long bear market
followed by an abrupt market upswing. Moreover the authors study what
happens to momentum portfolio during crashes and find that conditional market
exposure is the culprit. That is, by buying winners and selling losers, a
momentum strategy following a bear market will be long low beta stocks and
short high beta stocks. Then, when the market suddenly upswings, being short
high beta stocks will be a bad strategy.
 Recent Literature

 RELATIVE vs ABSOLUTE MOMENTUM

 Moskowitz, Ooi and Pedersen, «Time Series Momentum», Journal of Financial
Economics, 2012.
Idea: the authors document significant “time series momentum” in equity index,
currency, commodity, and bond futures for each of the 58 liquid instruments we
consider. A diversified portfolio of time series momentum strategies across all
asset classes delivers substantial abnormal returns with little exposure to
standard asset pricing factors and performs best during extreme markets

 Gary Antonacci, «Risk Premia Harvesting Through Dual Momentum», 2013.

Idea: this paper describe a methodology that permits investors to harvest risk
premia through a dual momentum strategy. A dynamic combination of relative
momentum with absolute momentum could enhance noticeably the overall
performance reducing negative volatility.
 Recent Literature

 DIFFERENT MOMENTUM APPROACH

 Chaves, Eureka! A Momentum Strategy that also works in Japan, 2012. Idea:
Chaves propose a different methodology to form momentum portfolios. Using
idiosyncratic returns from market regressions risk-adjusted performance increase
sharply making the strategy works even in Japan. The main improvement in
performance comes via a sharp reduction in volatility.

 Blitz, Huij and Martens, Residual Momentum, 2013. Idea: Conventional

momentum strategies exhibit substantial time-varying exposures to the Fama and
French factors. The authors show that these exposures can be reduced by
ranking stocks on residual stock returns instead of total returns.

 J. Wei, Do Momentum and Reversal coexist?, 2010. Idea: The author finds that
momentum works best for high volatility stocks, while reversal works best for low
volatility stocks.
 Recent Literature

 DEFENDING MOMENTUM STRATEGY

 Asness, Frazzini, Israel and Moskowitz, Fact, Fiction and Momentum Investing,
Journal of Portfolio Management, 2014. Idea: In this article, the authors aim to
clear up much of the confusion by documenting what it is know about momentum
and disproving many of the often-repeated myths. They highlight ten myths about
momentum and refute them, using results from widely circulated academic papers
and analysis from the simplest and best publicly available data. Momentum is very
strong; it is just as strong on the long side as the short side, works equally well
among large cap as it does among small cap stocks and is certainly profitable
after trading costs!
 Momentum
in a
Portfolio Perspective
 Risks

• Large and persistent losses in some years

• Poor performance in 2000–2003 (value did well)
• Poor performance in 2009 (value did ok)

• Far from a pure arbitrage

• Industry sector/ exposure makes it less diversified
• Introduces additional tracking error

• Highest momentum stocks may be overpriced

• But,…combining with value mitigates these risks

Rolling 5 Years Excess Returns of Momentum Over Market
Rolling 5 Years Excess Returns of Value Over Market
Momentum vs. Value Over Different Horizons
Rolling 5 Year Excess Ret of Growth over Market
Momentum vs. Growth over Different Horizons
Value and Momentum Excess Ret over Market

A. Buraschi
Growth and Momentum Excess Ret Over Market
 Implementing Momentum

• Higher turnover than other passive indices (value and growth)

• But, it’s a “good” kind of turnover

• Tax and trading costs are (always) important considerations

• Momentum is quite tax efficient, similar to other styles

• Historically, outperformance larger than these issues

• Need expertise in trading and implementing momentum

 Global Asset Allocation
and
Asset vs. Risk and Style Investment
Momentum in other Equity Markets
Momentum in other Asset Classes:
(Equity – FX – Bond – Commodity)

© Imperial College Business School

(Momentum + Value) vs. Market
 Asset Allocation
Rolling 5 Year Excess Returns of (Val + Mom) over Market
Asset Allocation: Real World Portfolios
 Rolling 5 Year Returns of 50/50 AQR Momentum Index

and Russell 1000 Value Index over Russel 1000 Index

 Alternative Perspectives about Effective Diversification
You can imagine at least 3 ways to think portfolio allocation:
1) by Asset Class,
3) by Risk Factor
2) by Strategy Style
 Styles Tend To Be Underutilized
Styles are deviations from market-weighted benchmarks based on certain
characteristics or risk exposures
• Style investing may help in both of the twin challenges
• Style diversification is more effective than asset class diversification
• To be most effective, style diversification requires leverage and shorting

Which styles show most consistent long-run rewards?

• Value – overweight assets with low valuations
• Carry – overweight assets with high income
• Trend / Momentum – overweight assets with high recent returns
• Low Risk – overweight assets with low beta or low volatility
• Illiquidity – overweight assets with low liquidity
 I. Long-Run Rewards
Separate from
Sources Major
of Long TermReturn
Returns Sources

Long History (ending in Dec 2009)

Compound Annualized Sharpe Start
Average Return Volatility Ratio Year

Asset Class Risk Premia

Global Equity Premium 4.5 17.3 0.35 1900
US Equity Premium 5.2 20.1 0.37 1900
World Term Premium 0.7 8.4 0.11 1900
US Term Premium 1.4 6.7 0.26 1952
US Credit Premium 0.3 4.4 0.08 1926
Active strategies
Value (Global Equity Selection) 4.6 7.2 0.68 1975
Carry (Currency G10 Selection) 6.7 10.3 0.67 1978
Trend (Commodity Trend-following) 10.2 12.1 0.85 1961
Volatility Selling (Equity Index) 4.2 15.3 0.35 1990
Carry-Seeking Composite 6.9 9.8 0.76 1970
Trend-Following Composite 9.6 10.2 0.99 1961
Bet-Against-Beta Composite (Frazzini-Pedersen) 8.5 8.9 0.95 1965
Liquidity Risk Factor in Stocks (Pastor-Stambaugh) 5.1 12.3 0.47 1968
Note: All asset class premia are excess returns over US T-bills except for the credit premium which is over long-dated Treasuries. All active strategies
show long-short returns. No trading costs or fees have been subtracted.

Sources: Ilmanen (2011). Bloomberg, Bank of America Merrill Lynch, Barclays Capital, Center for Research in Security Prices, Citigroup, Dimson-Marsh-Staunton (2010), Ibbotson
Associates (Morningstar), Ilmanen (2011), Kenneth French’s website, Frazzini-Pedersen (2010), Lubos Pastor’s website. For illustrative purposes only. The returns above do not
represent the return of an actual fund or AQR product.
 Style #1: Value
The Best-Known Style, Value, Has Given a Long-Run Edge in Stock Selection

Historically, value stocks (with low multiples) have outperformed the market and growth stocks
(with high multiples) over decades in all markets studied
Value also works in country/sector selection and in other asset classes
Both behavioral and risk-based explanations; both may contribute
Value-vs-Growth Cumulative Outperformance
1926-2009 (US) / 1975-2009 (non-US)
10,000
Log scale (Jan '75=1000)

1,000

100
Source: AQR Capital Management. Simulated trading strategies gross of
trading costs and fees. For illustrative purposes only. The returns above
do not represent the return of an actual fund or AQR product.
US Non-US
Source: Kenneth French’s website. For U.S. stocks (blue line since 1926, “US”), value (growth) stocks are
defined by high (low) book-to-market ratios. For the international stocks (green line since 1975, “nonUS” or 20
other countries), value and growth stocks are defined by a composite of four valuation ratios (book-to-market,
earnings-to-price, dividend-to-price, cash flow-to-price).
 Style #2: Carry
In the long run, carry-seeking works in virtually every asset class or context
Stronger performance in cross-country strategies than within-country
Carry strategies are clearly risky; rare large losses concentrate in “bad times”

Cumulative Excess Returns of Carry-Seeking

Strategies in Four Asset Contexts, 1993-2009
700

600

500

400

300

200

100

0
Source: AQR Capital Management. Simulated trading strategies gross
of trading costs and fees. For illustrative purposes only. The returns
above do not represent the return of an actual fund or AQR product.
FX G10 FX Emg FI G10 Credits

Sources: Ilmanen (2011), Bloomberg, Barclays Capital, Citigroup, J.P.Morgan

 Style #3: Momentum/Trend
Trend-following strategies tend to work well at intermediate horizons (1-12
month)
Over longer (1-5yr) horizons, reversals tend to dominate perhaps because
investors extrapolate multi-year growth or returns
Similar momentum-oriented strategies also work across stocks

Cumulative Excess Returns of Trend-Following

600 Strategies in Four Asset Contexts, 1993-2009
500

400

300

200

100

0
Source: AQR Capital Management. Simulated trading strategies gross
of trading costs and fees. For illustrative purposes only. The returns
above do not represent the return of an actual fund or AQR product.
Cmdty Futures Equity Indices Bond/Rate Futures Foreign Exchange

Sources: Ilmanen (2011), Bloomberg.

 Note: Trend/Momentum Diversifies Pro-Risk Investments
Trend-following strategies have been historically negatively correlated with
carry-strategies and equity market during financial crises.
Some exposure may help diversify risky portfolios when it is most needed –
and add some patience to a contrarian/value bias.

Returns for Carry and Trend Styles in the 15 Worst Months for Global Stocks, 1985-2009
20%
Oct-08
15%

10% Sep-01
Aug-98
Monthly Excess Return

Sep-08 Sep-02 Sep-90 Feb-09 Aug-90 Feb-01 Jul-02 Jun-08

5% Jan-08 Aug-97
Jan-09
Oct-87
0%

-5%

-10%

-15%

-20%

-25%

-30% CarryAll Excess (avg -5%) TrendAll Excess (avg +4%)

Source: Ilmanen (2011)

Style #4: Volatility (Insurance) Selling Earns a Risk Premium...
Volatility selling on equity index options is the purest form of selling financial
catastrophe insurance, but many carry-seeking and liquidity-premium-
harvesting strategies are its close cousins
These strategies can also be viewed as selling lottery tickets that pay off in bad
times. The terrible timing of the rare losses, rather than large magnitude or
asymmetry, warrants high risk premia
The risk is highly systematic, unlike most classical or catastrophe insurance

Cumulative Rewards to Three Ways of “Selling Financial Catastrophe Insurance”, 1989-2009

480
430
380
330
280
230
180
130
80

S&P Index Volatility Selling (MLHFEV1E Index) FX Carry Strategy (G10 High3 - Low3), start 1993
Front-End Credit Carry Strategy (AAA/AA1-3yr - Tsy, x10)

Sources: Bloomberg, Bank of America Merrill Lynch, Barclays Capital, Ilmanen (2011).
What does not Work?
 1. Beta is poor source of Expected return
Embedded leverage in high-risk assets contributes poor performance of high-risk
assets may be due to lottery preferences and/or leverage constraints: People
overpay for lottery tickets and for embedded leverage.
Similar evidence in equity markets outside the U.S. and within other asset markets
Betting against beta (BAB) has paid off in all asset classes
Long-run Sharpe ratio

Source: Frazzini-Pedersen (2010) BAB Factor SRs – All Asset Classes 1964-2009. This table shows annualized Sharpe ratios of BAB factors across asset classes. BAB is a portfolio short (de-
leveraged) high beta assets and long (levered) low beta assets. .
2. Liquidity as a risk factor? Positive, but Unstable
Premia compensate for both asset illiquidity and sensitivity to liquidity droughts
Evidence for positive liquidity premia across stocks and in other asset classes
The 2007-09 experience made it clear that these premia too vary over time

One Example: Cumulative Outperformance of Illiquid U.S. Stocks Over Liquid Stocks, 1972-2010

Sources: Chen-Ibbotson-Hu (2011).

Thanks!