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Looking for a better Momentum factor

the smart beta etf vogue is no threat to factor investing

Despite the abundant academic literature evidencing a Momentum effect both in equity and fixed income markets, this factor is often treated with caution. Challenges associated with the practical implementation of Momentum strategies, such as market reversal risk, for example, can seriously damage performance and frequently deter investors. However, focusing on the idiosyncratic Momentum – based on each security’s abnormal returns – helps avoid these pitfalls, according to David Blitz, Matthias Hanauer and Milan Vidojevic.

Momentum is one of the strongest and best-documented market anomalies ever found in financial markets. The momentum effect is the tendency of stocks that have performed well in the past months to continue to do so in the subsequent period, and, conversely, of poorly-performing stocks to continue performing poorly.

Although a momentum effect had already been reported in the academic literature in previous decades, this phenomenon was not extensively documented before the early 1990s. In 1993, two professors from UCLA, Narasimhan Jegadeesh and Sheridan Titman, published what is often considered the first comprehensive study of the momentum effect.

But while momentum can be viewed as one of the most pervasive asset pricing anomalies, it is also particularly difficult to exploit in practice. There are two well-documented issues that could hamper the successful implementation of momentum strategies. First, a momentum strategy can earn high returns, but also faces significant drawdowns when markets revert or when investor sentiment towards one particular group of stocks suddenly changes. The second issue is that momentum investing often implies high turnover and trading costs.

Introducing idiosyncratic Momentum

These pitfalls remain a serious challenge for investors but recent academic studies may provide a solution. In the paper (see link below) published earlier this year on SSRN, David Blitz, Matthias Hanauer and Milan Vidojevic from Robeco’s quantitative research team, addressed the debate over the workability of the momentum factor from a different perspective. They focused on stock-specific – or idiosyncratic – momentum. This concept is not new. Back in the mid-2000s, Roberto Gutierrez and Christo Pirinsky, two academics from the University of Oregon and the California State University, had already identified a momentum effect in stock returns that was different from conventional momentum.

Based on securities data recorded on the NYSE, AMEX and NASDAQ stock exchanges from 1960 to 2000, the two researchers found that portfolios based on stock-specific abnormal returns tend to outperform those based on raw returns over the longer term. In other words: portfolios based on stock-specific momentum achieve higher risk-adjusted results than conventional momentum investment strategies.

Two distinct factors

These findings were later reconfirmed and expanded in a 2011 paper by Robeco’s David Blitz, Joop Huij and Martin Martens. But until recently, the research left important questions unanswered. For example, it failed to establish whether momentum and idiosyncratic momentum are different manifestations of the same factor, or actually represent two distinct factors.

This central issue is at the heart of the new study published by Blitz, Hanauer and Vidojevic. Focusing on US market data for the 1925-2015 period, the three authors show that building portfolios based on idiosyncratic, as opposed to total past returns, generates comparable average returns with half the volatility of a conventional momentum strategy.

More importantly, they find that idiosyncratic momentum is truly a distinct phenomenon, that cannot be explained by any of the well-established factors, such as market, size, value, profitability or investment. Moreover, Blitz, Hanauer and Vidojevic also argue that the various explanations frequently given in the academic literature for the conventional momentum effect do not seem to be the real drivers of idiosyncratic momentum. Indeed, the strong link between conventional momentum and investor overconfidence and overreaction, as well as risk-based explanations, is much weaker for idiosyncratic momentum.

These findings support the ‘underreaction’ hypothesis, already mentioned by Gutierrez and Pirinsky in their 2007 paper, as a major reason for the idiosyncratic momentum anomaly. The ‘underreaction’ hypothesis assumes that the diffusion of relevant information concerning stocks or bonds remains very gradual across the investment community. This explains why prices tend to adapt only slowly to news.

As a result, conventional momentum and idiosyncratic momentum should be regarded more as complements than substitutes. For example, idiosyncratic momentum could be used as a tool to distinguish between conventional momentum stocks with high future returns potential, because their price movements are more likely the result of an ‘underreaction’ to news and stocks with returns that may reverse as a consequence of a prior overreaction or simply a long term reversal.

Out-of-sample confirmation

Another important contribution of this new paper is the confirmation that idiosyncratic momentum shows robust performance in several international stock markets. Based on over two decades of out-of-sample data from four investment universes – Europe, Japan, Asia Pacific ex- Japan and emerging markets – to build distinct portfolios, the researchers found that idiosyncratic momentum still generated higher risk-adjusted returns than conventional momentum in all the regions considered. Moreover, the returns achieved by idiosyncratic momentum strategies in these different markets cannot be explained by the market, size, value, and total return (conventional) momentum factors.

These results are particularly significant for Japan, where conventional momentum was found to work only under specific conditions, which raised concerns over a possible data mining issue. Blitz, Hanauer and Vidojevic find that the idiosyncratic momentum of Japanese stocks included in the FTSE World Developed Index generated a statistically significant 0.44% return per month during the December 1989-December 2015 period. Ultimately, the reduced time-varying exposures to systematic risk factors of idiosyncratic momentum enhance the effectiveness of the strategy to such a great extent that they even solve the momentum puzzle in Japan.

Read the related research paper

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