Sunday, December 11, 2016

Gray and Vogel, Quantitative Momentum

It’s always noteworthy when the folks at Alpha Architect produce a new book. Their offerings thus far are Quantitative Value, DIY Financial Advisor, and now (well, actually not so “now” but my review copy was slow in arriving) Quantitative Momentum: A Practitioner’s Guide to Building a Momentum-Based Stock Selection System (Wiley, 2016). The most recent volume was written by Wesley R. Gray and Jack R. Vogel.

Momentum can, as countless studies have shown, be the basis of a sound trading strategy. Of course, implementing a successful momentum strategy is not as simple as buying strength. Between 1927 and 2014 buying short-term winners returned less than the risk-free rate while buying short-term losers outperformed the S&P 500. Long-term momentum is also a sub-optimal strategy. The sweet spot is, as has again been well documented, intermediate-term.

Less extensively researched is the path dependency of momentum. Using a simple algorithm based on the percentages of negative days, flat days, and positive days, the authors distinguish between high-quality momentum, which has a relatively smooth path, and low-quality momentum, which has a jumpy path. Over the same 1927-2014 timeframe, high-quality momentum outperformed low-quality momentum by about four percentage points annually and outperformed the S&P 500 by more than seven percentage points annually.

Since momentum is a highly seasonal anomaly, the authors recommend exploiting seasonality in timing portfolio rebalancing. The difference between the annual results of a rebalanced portfolio using seasonality and an agnostically rebalanced portfolio is about half a percentage point.

Gray and Vogel spell out their reasoning and their methods in detail. No black box here. No complicated math. And they make the case for the persistence of momentum outperformance into the foreseeable future. As they write, “strategies like value and momentum presumably will continue to work because they sometimes fail spectacularly relative to passive benchmarks.” So investors, both the DIY variety and professional fund managers, will be loath to commit to quantitative momentum strategies. The momentum anomaly will persist.

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