August 15, 2013

Momentum Tidbits...

A number of papers have aimed at improving on relative strength momentum in equities by adding enhancements to it such as analyst coverage, credit rating, business cycle placement, proximity to 52- week highs, and price acceleration. Li-Wen Chen and Hsin-Yi Yu have an interesting new paper called "Investor Attention, Visual Price Pattern, and Momentum Investing" that identifies price acceleration by looking at the concavity or convexity of returns. They do this by regressing price against time squared. Using long/short US stock prices from 1962 through 2011, they find that the exponential application of momentum almost doubles the risk-adjusted profits from conventional momentum.

There have been several studies comparing momentum risk-adjusted returns to those of other anomalies. None has come close to momentum. For example, the alpha from momentum has been twice as high as the alpha from value. Michael Nairne in his "Fantasy versus Factors" article has added to this body of evidence with the following charts from 1981 through 2012 that match momentum with these other factors from the Kenneth French database: total market, value, small cap, small cap, small cap value, and high quality.

The above studies pertain only to relative strength momentum. Trend following absolute momentum is relevant to the updated Dalbar statistics. Over the past 20 years ending in 2012, the S&P 500 had an annual return of 8.21%, while the average stock mutual fund investor earned 4.25%. Around 1.25% of this underperformance is due to mutual fund expenses. Mutual fund investors making poor timing decisions caused the remaining 2.7% of annual under performance. There is a strong propensity for investors to buy near market highs and sell near market bottoms due to fear and greed. Absolute momentum, by reducing downside volatility and truncating potential drawdowns, can make it easier for investors to stay the course and hold on to their investments during unfavorable market periods.