Taming the Momentum Investing Roller Coaster: Fact or Fiction?

Taming the Momentum Investing Roller Coaster: Fact or Fiction?

August 10, 2016 Research Insights, Momentum Investing Research
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(Last Updated On: January 18, 2017)

Intermediate-Term Price momentum, originally researched by Jegadeesh and Titman in 1993, documented a how recent stock returns tended to continue in the future. Stocks that were past winners (on average) continue to do well, while stocks that were past losers (on average) continue to perform poorly.

A natural inclination is to create a long-short portfolio to take advantage of this — buy the past winners and sell the past losers. Sounds like a great idea! On average, this is a good bet; however this strategy will crash from time-to-time, as shown by academics here. Sometimes the past winners perform poorly, while past losers perform well. And these crashes can be horrific — extreme events that persist over time. Wouldn’t it be great if there were some way to mitigate these crashes?

The authors of this paper decided to just that, by using simple stop-loss rules in an attempt to minimize the crashes. The rules are simple:

  1. Rebalance the long and short book monthly
  2. If a long position declines by 10% (or 5%), sell the position and stay in cash/RF until the end of the month.
  3. If a short position increases by 10% (or 5), cover the short and stay in cash/RF until the end of the month.

Hmm, stop loss rules. Do these work? According to the paper, YES! The largest monthly drawdown decreases from -49.79% to -11.36%, using equal-weight portfolios, and from -64.97% to -23.28% using value-weight portfolios.

Here is Table 1 from their paper:

Taming Momentum Crashes figure 1
Click to enlarge. The results are hypothetical results and are NOT an indicator of future results and do NOT represent returns that any investor actually attained. Indexes are unmanaged, do not reflect management or trading fees, and one cannot invest directly in an index. Additional information regarding the construction of these results is available upon request.

Clearly the average returns increase with the use of the stop-loss rules. If we examine the WML (Winners Minus Losers) rows, the average monthly returns appear to be the highest when using the 5% rule.

Our Analysis

First, this strategy requires daily analysis of every stock position and may be difficult for the average investor to implement. Second, if one examines the average returns to the winning stocks above, you see that the 10% stop-loss rule has a similar return to the simple momentum strategy (1.27% vs 1.24%) while the 15% rule is actually worse than the simple momentum strategy (1.20% vs 1.24%). The 5% stop-loss rule works the best on the winner portfolio, with an average return of 1.53%.

Another consideration is that the paper includes all stocks, including micro-cap securities which tend to make up ~50% of the stocks in the universe. For various reasons these stocks pose practical implementation problems, notably liquidity issues.

So we decided to do some analysis, and focused on what we consider to be mid to large-cap stocks, where these practical micro-cap issues are mitigated, and which represent all common stocks above the NYSE 40th percentile for market capitalization. Additionally, since shorting also poses certain practical challenges, we only examine the long-leg of the strategies below.

Here are the four portfolios that we examine:

  • MOM 10 EW Monthly: Top 10% of firms ranked on their past momentum (total return over the past 12 months ignoring last month). Portfolio is monthly-rebalanced and equal weighted.
  • MOM 10 EW (Daily 10% Stop Loss): Top 10% of firms ranked on their past momentum (total return over the past 12 months ignoring last month). Portfolio is monthly-rebalanced and equal weighted. If during the month any individual stock position is down 10%, sell the security on the day the rule is triggered and remain in cash until the end of the month, at which time the portfolio is rebalanced into the top 10% of momentum firms.
  • MOM 10 EW (Daily 5% Stop Loss): Top 10% of firms ranked on their past momentum (total return over the past 12 months ignoring last month). Portfolio is monthly-rebalanced and equal weighted. If during the month any individual stock position is down 5%, as with the above rule, sell the security and remain in cash until the end of the month, at which time the portfolio is rebalanced into the top 10% of momentum firms.
  • SP500 EW: Total return to the S&P 500, equal-weighted.

In the results below, all returns are gross, and no management fee or transaction costs are applied:

Returns from 1/1/1927 – 12/31/2013:

Taming Momentum Crashes figure 2
Click to enlarge. The results are hypothetical results and are NOT an indicator of future results and do NOT represent returns that any investor actually attained. Indexes are unmanaged, do not reflect management or trading fees, and one cannot invest directly in an index. Additional information regarding the construction of these results is available upon request.

What do you notice? While the simple, long-only portfolio performs better when comparing GAGR and Sharpe ratios, the 5% and 10% stop-loss rule portfolios have lower drawdowns and higher Sortino ratios. So are you ready to apply stop-loss rules? Before making a judgment, consider AN IMPORTANT CAVEAT — these returns are gross of fees. Column 1 is monthly rebalanced, while columns 2 and 3 are rebalanced monthly with additional intra-month trading daily. This adds significant transaction costs. So what’s the effect? Trying to figure out the trading costs on these strategies would be a huge research paper unto itself, but it certainly raises questions. Anyone seriously considering this strategy would probably want to take 300-600bps off the strategies (especially going back to 1927). That might eliminate all the benefits of the risk management strategy.

Overall, the stop-loss rules can help with drawdowns, but will cause more trading, thus adding expense and reducing performance. Also, the added complications involved in running a short book would increase complexity. As with many strategies coming out of academia that look great at first glance, the devil is clearly in the details.

Let us know your thoughts. You can learn more about our thoughts on momentum investing here.


 

Taming Momentum Crashes: A Simple Stop-Loss Strategy

Abstract:

In this paper, we propose a stop-loss strategy to limit the downside risk of the well-known momentum strategy. At a stop-level of 10%, we find, with data from January 1926 to December 2013, that the maximum monthly losses of the equal- and value-weighted momentum strategies go down from -49.79% to -11.36% and from -64.97% to -23.28%, while the Sharpe ratios are more than doubled at the same time. We also provide a general equilibrium model of stop-loss traders and non-stop traders and show that the market price differs from the price in the case of no stop-loss traders by a barrier option.


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About the Author

Jack Vogel, Ph.D.

Jack Vogel, Ph.D., conducts research in empirical asset pricing and behavioral finance, and is a co-author of DIY FINANCIAL ADVISOR: A Simple Solution to Build and Protect Your Wealth. His dissertation investigates how behavioral biases affect the value anomaly. His academic background includes experience as an instructor and research assistant at Drexel University in both the Finance and Mathematics departments, as well as a Finance instructor at Villanova University. Dr. Vogel is currently a Managing Member of Alpha Architect, LLC, an SEC-Registered Investment Advisor, where he heads the research department and serves as the Chief Financial Officer. He has a PhD in Finance and a MS in Mathematics from Drexel University, and graduated summa cum laude with a BS in Mathematics and Education from The University of Scranton.


  • JAK78

    Why do people concern themselves with momentum crashes? These only happen due to the price action of short positions. Most people don’t use momentum with stocks sold short.

  • That is an academic practice, but as you point out, in the real world the vast majority of people are not running long/short portfolios. Of course, in defense of academic researchers, their goal is no to devise practical portfolio constructs but to highlight the evidence for competing hypothesis.

    Stepping back, your comment brings up a great point and highlights that your level of understanding is much higher than the rest of the pack. Many consumers of financial research do not pay enough attention to the source research journals and often confuse results associated with long/short portfolio analysis and incorrectly apply the research take-aways to long-only portfolios.

  • Pete Arnold

    Great to see something approaching a real-world implementable strategy. There certainly is a great number of monthly transactions going on even with the “vanilla” momentum approach – rebalancing and adding/deleting individual positions. I disagree, though, that the use of stop-loss significantly increases the number of transactions. If you’re stopped out of a position, don’t you just wait out the month in cash and then rebalance? It should be the same number of transactions. Also, if a position is stopped out I’d think that statistically predisposes it to exclusion from the mix at the next rebalancing. I admit, though, that there are still a lot of moving parts – better something to do on a large institutional platform rather than as an individual investor.

  • Hey Pete,
    Definitely doable for a professional–could build a system with some time/effort.
    The stop causes you to sell a lot intra month even though that stock may not be sold in the monthly rebalance. this is especially the case with the 5% rule. If you are only trading uber deep/liquid it wouldn’t be a huge deal. Anyway, agree with your general statement that with some effort and a professional trading desk you could make this work…

  • Johan

    What do you think about “Momentum Crashes” by Kent Daniel and Tobias J. Moskowitz?

    http://faculty.chicagobooth.edu/tobias.moskowitz/research/mom11.pdf

    It seems like the momentum crashes are predictable.

    Quote from the paper:

    “Moreover, these crash periods are predictable: we use bear market
    indicators and ex-ante volatility estimates to forecast the conditional mean and variance of
    momentum strategies. Armed with these estimates, we create a simple dynamically-weighted
    version of the momentum portfolio that approximately doubles the Sharpe ratio of the static
    momentum strategy and is not spanned by constant volatility momentum strategies or other
    factors – doing so consistently in every market, asset class, and time period we study.”

  • Hey Johan,

    If you are running a long/short momentum portfolio, protecting against momentum crashes is a good idea. Following a massive bear a l/s momentum strat is essentially long low beta and short high beta, which ends in a nasty surprise if there is a ripping rally in the broader market (see 2008 to 2009 for the UMD factor on Ken French’s site). So yes, that makes sense.

    If you are running long-only momentum this is less of a concern, but something to think about. We like to leverage trend-following rules to manage exposure but a volatility-like signal accomplishes the same goal.

    Good luck

  • Johan

    Thanks for the response Wesley!

    Would I be correct in assuming that eliminating momentum crashes would significantly(!) reduce the maximum drawdown (that you and Jack Vogel talked about in the paper “Using Maximum Drawdowns to Capture Tail Risk”)? And potentially making a l/s momentum strategy worth the added operational risks?

    And regarding trend-following rules: What do you think about using time series momentum on equity indices (say 1-Month, 3-Month & 12-Month, as is described in the paper “Demystifying Managed Futures” by Brian Hurst, Yao Hua Ooi, and Lasse Heje Pedersen, http://docs.lhpedersen.com/DemystifyingManagedFutures.pdf ) to determine the net exposure (in the momentum strategy)?

    Would you get margin calls if you did something like that?

  • Historically that has been the case, but who the heck knows in the future.

    I’m a big fan of trend-following managed futures programs, but these programs certainly aren’t for everyone and can certainly get into margin call issues if you are using leverage.