In this series of articles, we’ll dive deeper into factor investing, how they are constructed and found, and how you can start investing in factors. Last time we started with the basics of what factor investing is. This time we will dive deeper into the most successful factor that has stumped many academics as to why it exists: momentum. We will discuss how its constructed, why it might actually also be the riskiest factor and what possible alternative investment strategies exist to momentum.
Momentum is one of the most widely studied risk-factors and has seem to have existed for over 200 years (Asness et. al), not only in stocks but other asset classes as well and in different international markets. You could say that it is one of the most persistent factors across time. Eugene Fama struggled to define an economic intuition as to why this factor performs the way it does but generally momentum could be attributed to human biases that influence investor behaviours.
It was first discovered by Jegadeesh and Titman (1994) discovered that past winners, that is stocks that have performed well in the last 12 months, tend to outperform past losers. This was later put into a four-factor model made popular by Carhart in 1997. The Carhart 4-factor model is an extension of the Fama-French 3-factor model, but now includes momentum as a risk-factor to explain stock returns.
What is momentum actually and how I it constructed? Within investments, momentum refers to a strategy that invests in well performing stocks and shorts poorly performing stocks, a similar construction as SMB from our last article (here). So, how is it constructed? Stocks are ranked on their past 12-month returns (often skipping the month January – so actually 11 months) and then sorted into portfolios where one portfolio has high prior returns and the other low prior return. The reason to skip January is to avoid the “January effect”, the perceived tendency of stocks to rise in that month. It has been theorized that institutional investors sell stocks to take year-end profits and buy again in January – causing a rise in prices. To isolate the momentum premium, we short the low prior return portfolio and go long in the high prior return portfolio, creating winners-minus-losers (WML) portfolio.
If we compare the performance of momentum with the other popular factors, it’s quite clear that momentum (blue line, WML) is the most successful in terms of absolute returns and risk-adjusted returns. The graph below plots the returns of a single dollar investment in each of the factors, starting from 1927 until 2020. If you invested a single dollar in WML from 1927 and didn’t do anything with it until 2020, your $1 portfolio would now be around $360 – or returned over 36000%. If you compare this to SMB or HML, they merely reach 500% and 2000% over the same period.
We resort to the annualized Sharpe Ratio to measure each factor’s risk-adjusted returns and its clear again that momentum is the winner here. The Sharpe Ratio is calculated as the average excess return divided by the factor’s standard deviation over the sample period.
So, it’s clear that momentum is the most successful in terms of returns, so why isn’t everyone just doing momentum? In the next article of the series, we will dive into variants of the momentum factor as an answer to the downfalls of this lucrative strategy.