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The Analysis of a Momentum Model and Accompanying Portfolio Strategies

The Analysis of a Momentum Model and Accompanying Portfolio Strategies

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Momentum; ETFs; Portfolio Theory; Empirical Research
Momentum; ETFs; Portfolio Theory; Empirical Research

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Categories:Types, Research
Published by: Robert T. Samuel III on Jun 30, 2013
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07/08/2013

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The Analysis of a Momentum Model and AccompanyingPortfolio Strategies
Robert T. Samuel III
Draft version: 8 July 2013
Abstract
We analyze the performance of a proprietary momentum model and accompany-ing portfolio strategies using a universe of twenty-three US Exchange Traded Funds(ETFs). For the simulation period of October 3, 2001 through May 1, 2013 we findthat our model does outperform the traditional momentum model across all strategyvariation. However, both models underperform a simple Buy & Hold strategy for theassets and time period selected. In addition to these results, we introduce a dynamicthreshold algorithm that determines ex ante the number of stocks to include in a port-folio. The results from this algorithm show that it is able to capture most of therisk-reward profile of the optimal portfolio.
1 Introduction
Momentum has historically possessed strong explanatory power within an asset pricingframework. Jegadeesh & Titman (1993) look at the performance of stock portfolios formedon a momentum rank, sometimes called ’cross-sectional’ or ’relative’ momentum, and findstatistically significant positive performance even when controlling for systemic and otherrisk factors. Specifically they find that historic time frames of a year, the ’formation period’,in conjunction with a holding period of three-to-twelve months yield superior results. Thisextended research by de Bondt & Thaler (1985) which found winners outperforming losers,albeit only in January, and which is attributed to some of the behavioral biases discussedin Kahneman & Tversky (1982). Chan et al (1996) find that portfolios of US stocks formedbased upon returns for the past six months provide economically meaningful returns overthe next six months. In addition, these returns are not highly correlated with returns of portfolios formed based upon earnings momentum. They go on to offer several theories forprice momentum including under-reaction to past information, but refute theories associatedwith a positive-feedback mechanism. Cahart (1997) documents the presence of a momentumfactor in addition to the traditional Fama-French 3-Factor model, in explaining the returnsof portfolios of mutual funds. However, he goes on to state that based upon the data it ap-pears that the presence of this explanatory factor is due to managers holding onto winning
Correspondence: rtsamuel3@gmail.com
1
 
stocks and not an attempt to profit from momentum strategies. Rouwenhorst (1998) looksat the performance of momentum in international markets and find evidence that portfoliosconstructed in the manner of Jegadeesh & Titman provide positive returns for the period of 1980-1995 and for all countries studied.Jegadeesh & Titman (2001) again looked at the performance of momentum strategies andfind for the period of 1990-1998 that portfolios with a positive momentum factor loading out-perform those with a negative factor loading for up to twelve months after the formationperiod. In addition they look at the performance up to sixty months after formation and finda reversal which repudiates the claims of other authors that momentum is a measurementof the unconditional expectation of returns. This revelation adds credence to behavioraltheories which postulate that momentum is due to under/over-reaction to information bytrading agents. Fama & French (2012) analyzed the performance of the four-factor modelin explaining the excess returns of stocks globally and found that ex-Japan, momentum wasa strong explanatory factor. Baltas & Kosowski (2012) look at ’time-series’, or ’absolute’,momentum with futures and again find statistically significant performance for the one yeartime frame in conjunction with a one month holding period. Moskowitz et al (2012) also lookat time-series momentum using excess returns and find statistically significant positive re-turns across multiple asset classes that exhibit persistence up to twelve months. Novy-Marx(2012) found that by lagging the formation of a portfolio based upon a momentum factoryielded superior returns to just forming portfolios immediately after calculation. Lastly, An-tonacci (2013) finds that combining cross-sectional and absolute momentum yields superiorresults when utilized upon different asset classes.Given the breadth of literature that documents the presence of a momentum factorwithin financial asset returns, we strive to develop a momentum model that encapsulatesthis empirical research. In the following sections we will cover the assets to be tested, themethod of testing and a discussion of the results
1
.
2 Data
We use daily Open, High, Low, Close, Adjusted Close, Volume and Dividend data fromYahoo! Finance for the ETFs listed in Table 1
2
. We employ ETFs for our analysis primarilyto avoid having to establish point-in-time constituent members of a set of assets which wouldnormally lead to ’survivorship bias’
3
. For a cash balance reference rate we use the DailyEffective Fed Funds Rate and for a risk-free rate we use the 3-Month Treasury Bill: SecondaryMarket Rate both from the from the St. Louis Federal Reserve Economic Database (FRED)
4
1
Upon request, we can furnish an addendum which lists the tests, and statistics, along with their imple-mentation.
2
Data from http://finance.yahoo.com/.
3
’Survivorship Bias’ is the phenomena where a historic analysis is done on the current set of assets whosemembership in that set are influenced by their relative performance to other assets. In these scenarios thesimulated performance of a strategy may be influenced if the current set is used and not a point-in-timemembership.
4
Data from http://research.stlouisfed.org/fred2/series/DFF and http://research.stlouisfed.org/fred2/series/DTB3respectively. In regards to the 3-Month Bill rate there were twenty-four days with no data due to Columbus’Day and Veteran’s Day. In this case we used an estimate for that day’s rate,
t
, using the time-series
2
 
with descriptive statistics found in Table 2. In Table 3 we can see descriptive statistics onthe adjusted daily closing prices for the specified ETFs
5
. Jarque & Bera (1987) developed aLagrange Multiplies statistic to test for non-normality using the sample skewness and samplekurtosis and looking at our price series we see that we reject the null hypothesis of normalityfor all series. In addition, Ljung & Box (1978) developed a portmanteau test to determineif the observations within a time series are independent by looking at lagged values and wesee that for all of our price series that the null hypothesis is rejected for a specified lag of 1.In Table 4 we list the descriptive statistics for the returns, using the convention of 
r
t
=
log
(
t
)
log
(
t
1
), for adjusted closing prices. Mandelbrot (1963) documented thenon-normality exhibited in lognormal price changes for financial data, and we can clearlysee that all of the series exhibit non-normality. In addition, most reject the null hypothesisof independence. Bollerslev (1986) developed an extension of the the Autoregressive Condi-tional Heteroscedascity (ARCH) which he termed General ARCH (GARCH) that tests forconditional changes in the variances. In our table we see that all of series follow a GARCHprocess with a statistically significant ARCH process as well. Chow & Denning (1993) pro-posed a multiple variance test to test the null hypothesis that a time-series was a randomwalk. Given our evidence of heteroscedascity in all of the data series, we focus on the
M
2
statistic they developed and see that for more than half of our data series we can rejectthe null hypothesis of a random walk series. This is significant in that when our modelsidentify a trend it is not due to drift caused by past random disturbances. Lastly, Kruskal& Wallis (1952) developed a multivariate test to determine if samples come from the samedistribution, and although we do not report it, the test failed to reject the null hypothesisand therefore there is insufficient evidence to conclude that any of the returns come from adifferent distribution than the others.
3 Model, Portfolio Strategies & Competing Models
3.1 Model
We develop a momentum model, denoted as ’MM’, which attempts to quantify the strengthof a trend by outputting a real value number using three parameter values which determinethe appropriate historical time period and smoothness of the model output. For our analysiswe select parameter settings so as to focus on longer-term trends, and in an effort to reduceturnover, we preference a smooth output
6
. Given these objectives, we develop a model andwish to perform an initial evaluation of its merits. Our proportion of interest is
ρ
MM 
=
 j
=1
i
=2
[sgn(
 j,i
1
) = sgn(
D
 j,i
)]
(
1)(1)
model of 
t
=
α
+
βX 
t
1
+
which we calculated using Ordinary Least Squares (OLS) with a sample sizeof fifteen days. We acknowledge this is a crude approximation but given the number of estimations maderelative to the overall size of the sample, we feel it is sufficient.
5
We use adjusted closing prices as they adjust for price impact of ex-dividend and splits. In addition, forall of our models we use the adjusted close, or a derivation of, for calculation purposes.
6
We tested two parameter settings in total, both based upon the empirical research, but chose settingsthat were based upon the research of Moskowitz et al and Baltas & Kosowksi.
3

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