Stock momentum is a high turnover strategy, and many momentum stocks are volatile with wide bid-ask spreads. There is bound to be some price impact from trading momentum stocks. This is especially true with frequently balanced, concentrated momentum portfolios.
Everyone now knows the top-ranked momentum stocks. In fact, Alpha Architect shows the top 100 momentum stocks on their website each month to anyone who registers there. So all investors, not just multi-billion-dollar asset managers, may experience adverse price impact from trading the same momentum stocks that everyone else does.
Transaction costs can be a similar problem. W&J mention a paper called "The Illusionary Nature of Momentum Profits" by Lesmond, Schill, and Zhou (2002) published in the Journal of Financial Economics. Lesmond et al. conclude that after transaction costs, momentum profits are largely illusionary. W&J also mention research by Korajczyk and Sadka (2004) showing that stock momentum has a limited capacity of only about $5 billion.
Offsetting these arguments, W&J present the findings of Frazzini, Israel, and Moskowitz (2014) of AQR. Frazzini et al. argue that momentum trading costs are manageable based on AQR’s own proprietary transaction data from 1998 through 2011.
But the amount of capital in momentum strategies is higher now. In a more recent paper, Fisher, Shah, and Titman (2015) use observed bid-ask spreads from 2000 through 2013. They report, “Our estimates of trading costs are generally much larger than those reported in Frazzini, Israel and Moskowitz (2012), and somewhat smaller than those described in Lesmond, Schill and Zhou (2004) and Korajczyk and Sadka (2004).” Research by Jason Hsu PhD, co-founder of Research Affiliates, also supports the higher transaction cost conclusions of Fisher et al. and Lesmond et al.
Scalability and transaction costs are reasons why we prefer to use momentum with indices and asset classes rather than with individual stocks. Another reason is that according to Geczy and Samonov (2015), momentum applied to stock indices outperforms momentum applied to stocks even before transaction costs.
Chapter 6 is where W&J explain path dependency is and why it matters. They cite research by Da, Gurun, and Waracha (2014) showing that smooth and steady past performance is preferable to jumpy performance. The underlying logic is that investors underreact to continuous information. Investors should therefore prefer momentum accompanied by steady price appreciation rather than discreet price jumps.
To implement this idea, W&J advocate double sorting stocks on their 12-month momentum and their percentage of positive daily returns over the past 252 trading days. What they call “high-quality momentum" are top decile momentum stocks with the largest percentage of positive daily returns. Results are from 1927 through 2014. Transaction costs are not included.
The improvement in high-quality over generic momentum looks good. But a possible warning sign is W&J’s statement at the beginning of Chapter 6: “For over a year, we examined every respectable piece on momentum stock selection strategies we could find…”
In Chapter 7 W&J attempt to further enhance momentum by adding seasonality. In the turn-of-the-year or January effect, investors engage in year-end tax loss selling. They hold on to their strongest stocks and may buy more of these as replacements for the stocks they sell.
Window dressing to make their quarter-end portfolios look more attractive may also cause investment professionals to sell their losers and buy more winners before the end of the quarter. To take advantage of these seasonal tendencies, W&J advocate rebalancing their momentum portfolios at the end of February, May, August and November. They say this may help capture higher momentum profits during the months following the end of each calendar quarter.
Here are the results from incorporating seasonality as “smart rebalancing.”
There is little risk-adjusted improvement over agnostic (generic) momentum as seen from the increase of only .01 in the Sharpe and Sortino ratios. But since portfolios are rebalanced quarterly anyway, there should be no harm in picking non-calendar ending quarters for doing so.
In Chapter 8 W&J suggest that readers address the trading cost issue by comparing the analysis presented in Lesmond et al. and Frazzini et al. They do not mention here the more recent studies by Fisher et al. and Hsu that I discuss above.
W&J then do an in-depth analysis of “quantitative momentum” with respect to reward, risk, and robustness. They finish the chapter by making the point that momentum is sustainable because investors will continue to have behavioral biases. Investors are short-sighted performance chasers. This should also keep them from overexploiting the anomaly.
In the words of W&J, “… strategies like value and momentum presumably will continue to work because they sometimes fail spectacularly relative to passive benchmarks.” This may not be good news for those who at that time own momentum or value stocks. But W&J offer these words of encouragement. “The ability to stay disciplined to a process is arguably the most important aspect of being a successful investor” (emphasis added).
In Chapter 9 W&J show a combined 50/50 allocation to an equal weight, quarterly rebalanced momentum and value portfolio from 1974 through 2014.
The combined portfolio return is higher than that of momentum or value on their own. The combined portfolio also has less tracking error than either momentum or value vis-a-vis the broad market. Combining value and momentum shortens both the length and depth of benchmark underperformance.
As a final tweak to their approach, W&J show a trend following overlay applied to the combined portfolio. If a 12-month moving average of the S&P 500 index is greater than zero, they hold the combined portfolio. If the moving average is less than zero, they hold Treasury bills. Using this trend filter, the worst drawdown of the combined approach goes from -60.2% to -26.2%. But investors give up 1.5% in compound annual return, and there is an increase in tracking error.