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a proper accounting for transactions costs and risk*

Sam Tretheweya, Timothy Falcon Crackb

a

PricewaterhouseCoopers, Auckland, New Zealand

Department of Finance and Quantitative Analysis, University of Otago, Dunedin, New Zealand

Abstract

We test for recently reported momentum prots in New Zealand using a practitioner technique that we have not yet seen in the academic literature. This technique simultaneously weighs returns, risk and transactions costs at each

portfolio rebalance, rather than blindly chasing returns and then accounting for

risk and transactions costs after the fact. We reverse the ndings of the earlier literature because our gross prots are more than fully consumed once transactions

costs are properly accounted for. Although we focus on momentum trading in

New Zealand, our practitioner technique is broadly applicable to investigations

of trading anomalies.

Key words: Price momentum; New Zealand; Price impact; Market eciency;

Equity trading

JEL classication: G11, G14

doi: 10.1111/j.1467-629X.2010.00355.x

1. Introduction

We test for recently reported prots from price momentum trading strategies

in the New Zealand stock market (Gunasekarage and Kot, 2007; Stork, 2008). A

particular strength of the paper is the use of a practitioner technique for optimal

portfolio rebalancing subject to risk and transactions costs; we have not seen this

technique used before in the academic literature. Our simplest unconstrained

* The opinions expressed in this paper are those of the authors and do not necessarily

represent those of PricewaterhouseCoopers. We thank Simon Benninga, Robin Grieves,

an anonymous asset manager working for a bulge bracket investment bank and an

anonymous referee for helpful comments. Any errors are ours.

Received 18 December 2009; accepted 2 March 2010 by Robert Fa (Editor).

2010 The Authors

Accounting and Finance 2010 AFAANZ

942

momentum portfolio generates gross returns of 185 basis points (bps) per month

over the July 1992 to September 2006 period in line with earlier literature. This

compares very favourably with an NZSE40/NZX50 (i.e. New Zealand Stock

Exchange) benchmark return of only 78 bps per month over the same period.

After accounting for transactions costs, risk and other practical considerations,

however, our realized net return falls to only 52 bps per month more than erasing the prots.

The paper proceeds as follows. Section 2 provides a review of selected literature on price momentum. Section 3 discusses the data and method. Section 4

presents our empirical results. Section 5 concludes.

2. Literature review

2.1. The price momentum anomaly

Levy (1967) concludes that superior prots can be achieved by investing in

securities which have historically been relatively strong in price movement.

Jegadeesh and Titman (1993) demonstrate that strategies that buy past winner

stocks and sell past loser stocks generate signicant excess returns. Jegadeesh

and Titman measure past performance over the prior three to 12 months and

allow for subsequent holding periods of three to 12 months. Price momentum of

this form has now been found by researchers in most markets: Rouwenhorst

(1998) reports signicant momentum eects in 11 out of 12 European countries

(Sweden is the exception); Leippold and Lohre (2008) report signicant momentum eects in the US and 14 out of 16 European countries (Ireland and Austria

are exceptions); Chui et al. (2000) report signicant momentum eects in seven

out of eight Asian countries (Japan is the exception); Hurn and Pavlov (2003),

Demir et al. (2004) and Stork (2008) report momentum prots in Australia; and

Gunasekarage and Kot (2007) and Stork (2008) report momentum prots in

New Zealand.

Fama and French (1996) suggest that momentum prots may be due to

data snooping. Jegadeesh and Titman (2001) respond to this with further

out-of-sample evidence, dismissing the Fama and French data snooping argument. Fama and French (1996) argue that, although many of the CAPM anomalies can be explained by their three-factor model, the momentum prots of

Jegadeesh and Titman (1993) are an exception. Fama and French (1996) suggest

that investors underreaction to recent news produces momentum eects, but

their overreaction to less-recent news causes a longer-term reversal. Daniel et al.

(1998) suggest that investors are overcondent about their own abilities and the

accuracy of their private information and that this leads them to push up the

prices of past winners and push down the prices of past losers. Barberis et al.

(1998) suggest sentiment-driven explanations for underreaction and momentum

prots. Hong and Stein (1999) assume that agents are bounded rational: They

are unbiased in their evaluation of information, but they evaluate only partial

2010 The Authors

Accounting and Finance 2010 AFAANZ

943

information, ignoring the rest. With heterogeneous agents and slow diusion of

information through the economy, this leads to underreaction in the short term.

Hong et al. (2000) follow up and conclude that this underreaction is especially

noticeable for negative news, and that momentum prots are stronger in small

stocks and stocks with low analyst coverage. Grinblatt and Moskowitz (2004)

nd that being a consistent winner can double the subsequent return associated

with being in the top momentum decile. Grinblatt and Han (2005) suggest that

the disposition eect (Shefrin and Statman, 1985) could be driving momentum

prots, because selling winners too soon and delaying the sale of losers would

generate price underreaction consistent with momentum. Sadka (2006) nds that

part of the return from momentum trading is compensation for bearing liquidity

risk. Given this brief review, it is fair to say that momentum prots are both

widely recognized and dicult to explain.

In New Zealand, two recent studies identify a strong price momentum eect

(Gunasekarage and Kot, 2007; Stork, 2008). Stork (2008) reports momentum

prots in New Zealand, but he focuses on very concentrated large capitalization

portfolios that are not suitable for institutional asset managers and he does not

account for transactions costs. Gunasekarage and Kot (2007) look at the performance of portfolios formed on the basis of recent three- to 12-month formation

periods. They form three equally weighted portfolios: relative winners, a middle

group and relative losers. They then look at subsequent performance of these

portfolios over three- to 12-month holding periods. They report momentum

strategy outperformance of an NZX index by 12.63 per cent per annum before

transactions costs and 8.80 per cent per annum after transactions costs (Gunasekarage and Kot, 2007, p. 114). They subtract only an arbitrary slice (one-fth)

of gross returns as an ad hoc transactions cost and do not account for actual

spreads or price impact. We argue below that our method is a signicant

advance on Gunasekarage and Kot (2007) and Stork (2008).

3. Data and method

3.1. Data

Our trading strategy uses monthly rebalancing of a portfolio of individual

New Zealand stocks, but some parts of the implementation require daily data.

We use securities that are members of the NZSE40 Capital Index and its replacement, the NZX50 Free Float Gross Index. Index membership, index member

weights and closing prices are obtained on a daily basis from the NZX for the

NZSE40 from June 1991 to March 2004 and for the NZX50 from March 2003

to September 2006. Further daily data from the New Zealand Stock Exchange

Database at the University of Otago are collected to identify bid-ask spreads,

dividend and stock split price adjustments and sector classications. Data are

cross-checked using Yahoo! Finance and the Otago University Bloomberg

Accounting and Finance 2010 AFAANZ

944

Terminal. The New Zealand Government three-month Treasury bill yield is used

as the risk-free rate of return.

Table 1 provides descriptive statistics for the stocks in the benchmark portfolio. Comparing 2006 with 1991, we see that liquidity has steadily improved over

the time series: The average market capitalization has roughly doubled; average

daily dollar turnover has more than tripled; and average relative spreads have

roughly halved.

Although not shown in Table 1, the corresponding time series improvement

in liquidity is even more dramatic for the median stock in each of the less

liquid turnover quartiles. Even so, signicant dierences in liquidity remain in

the cross-section: For example, by the end of the sample, the median stock in

the least liquid turnover quartile still has one-ninth the market capitalization,

two times the relative spread, and one twenty-sixth the daily dollar turnover of

the median stock in the most liquid turnover quartile. Any na ve momentum

trading strategy that fails to account for these cross-sectional dierences in

liquidity will bias us towards overly optimistic prots because, as we shall see,

it is the less liquid stocks with higher transactions costs that possess the most

attractive momentum characteristics. Sections 3.3 and 3.4 discuss how our

momentum strategy accounts properly for these liquidity and transactions

costs issues.

3.2. The benchmark portfolio

The performance of our momentum portfolio is measured against either the

NZSE40 or NZX50, depending on the time period. The NZSE40 Capital Index

consisted of the 40 largest publicly traded companies in NZ. All listed securities

from these companies were included in the index; therefore, the index regularly

had more than 40 constituents. Without loss of generality, we refer to the index

members as stocks because the non-stock index members (e.g. warrants and

convertible notes) were of very small capitalization. The NZSE40 was discontinued in March 2004, and the NZX50 was introduced. At the end of the NZSE40

period, we expand our portfolios universe of benchmark stocks to the NZX50.

The NZX50 comprises the 50 largest companies listed issues, subject to liquidity constraints. As of 18 November 2009, the 112 members of the NZSE All

Share had a total market capitalization of NZD46.1 billion, whereas the NZX50

securities had a total market capitalization of just over two-thirds this, at

NZD32.7 billion (Bloomberg Terminal, 2009).

To simplify various technical dierences in construction, we use the ocial

index weights obtained from the NZX for each index, but we record the dollar

growth in the benchmark portfolio using the same split- and dividend-adjusted

database returns that we use to calculate dollar growth in our active portfolios.

This creates a level playing eld for the competition between the benchmark and

the active portfolio. Our index growth is, therefore, slightly dierent from that

reported ocially by the NZX.

2010 The Authors

Accounting and Finance 2010 AFAANZ

1991

1992

1993

1994

Mean*

n/a

46

48

49

Panel B: Monthly stock returns (%)

Mean

2.65

1.65

2.44 )2.23

Median

1.62

0.00

0.18 )1.80

Standard

12.36 10.99 15.28 17.23

Deviation

Lower Quartile )3.17 )3.76 )3.49 )6.71

Upper Quartile

8.49

7.65

7.37

3.00

Panel C: Market capitalization ($NZD million)

Mean

614

629

728

909

Median

162

172

218

310

Standard

1208

1182

1476

1796

Deviation

Lower Quartile 64

85

103

184

Upper Quartile 431

396

483

715

Panel D: Turnover ($NZD thousand traded per day)

Mean

687

657

1185

1233

Median

85

144

249

234

Standard

1549

1108

2629

2782

Deviation

Lower Quartile 30

54

105

107

Upper Quartile 390

547

721

571

Year

Table 1

Sample descriptive statistics

Accounting and Finance 2010 AFAANZ

942

353

1933

182

841

1024

273

2178

123

633

171

728

1351

222

4194

94

574

)2.21

4.43

)2.20

4.57

948

302

1935

0.98

0.46

7.35

51

1996

0.89

0.80

8.05

47

1995

125

625

1152

259

2836

199

917

966

387

1997

146

1203

2091

363

6047

226

758

884

395

2023

)6.21

6.20

)0.01

0.00

12.32

)0.65

0.00

8.85

)4.43

4.00

52

1998

52

1997

143

1886

2101

501

6137

235

905

938

516

2075

)3.90

3.86

0.23

0.00

9.40

52

1999

89

1547

2006

458

5991

228

880

898

512

1836

)4.73

4.40

)0.16

0.00

10.17

52

2000

159

1520

1851

514

5233

210

1010

864

507

1402

)2.43

4.66

0.38

0.82

10.23

50

2001

157

1457

1660

479

5864

220

1059

942

517

1446

)3.89

3.66

0.21

0.00

12.01

45

2002

162

1536

1638

519

4508

184

967

839

387

1378

)1.68

5.81

1.84

1.75

9.48

46

2003

182

1366

1906

490

5934

217

1418

1251

447

1957

)0.97

4.63

1.75

1.60

7.58

51

2004

231

1482

2066

556

6320

289

1769

1296

536

1847

)2.97

3.84

0.14

0.00

7.15

51

2005

184

1698

2502

520

9386

291

2024

1305

593

1607

)2.83

4.17

1.24

0.47

6.16

51

2006

945

1991

1992

1993

Accounting and Finance 2010 AFAANZ

1.60

1.07

2.06

0.65

1.72

0.70

1.92

1995

1.73

1.17

2.05

1994

0.68

1.57

1.52

0.99

1.94

1996

0.69

1.68

1.58

1.06

2.19

1997

0.85

2.37

2.07

1.21

2.58

1998

0.57

1.83

1.55

0.96

2.14

1999

0.63

2.30

1.91

1.12

2.60

2000

0.56

1.61

1.50

0.91

2.26

2001

0.51

1.46

1.33

0.87

1.91

2002

0.55

1.35

1.43

0.83

2.87

2003

0.44

1.12

0.91

0.68

0.89

2004

0.46

1.09

0.95

0.77

0.91

2005

0.48

1.21

1.05

0.80

0.91

2006

*The mean number of rms represents the yearly average number of rms that were constituents of the NZSE40 or NZX50 and were therefore part of the

momentum portfolio. No momentum portfolios were formed in 1991; these data were used only to construct a historical variance covariance matrix. Panels

C, D and E use a pooled sample where each stocks data are observed on the rst trading day of the month (when the portfolio rebalance takes place), with

the turnover observation being the 40-day moving average used in the price impact calculation.

Mean

2.33

2.04

1.47

Median

1.53

1.41

1.12

Standard

2.55

2.71

1.26

Deviation

Lower Quartile

0.87

0.76

0.73

Upper Quartile

2.60

2.06

1.71

Year

Table 1 (continued)

946

S. Trethewey, T. F. Crack/Accounting and Finance 50 (2010) 941965

947

We execute a quantitative active equity alpha optimization, but with only one

signal: price momentum. This widely used practitioner technique is described in

detail in the practitioner book by Grinold and Kahn (2000a).1 A similar technique appears in Chincarini and Kim (2006, Chapter 9). We begin by constructing ex-ante alphas (also called signals) for each stock, each month using a

series of steps involving scaling and neutralization of raw alphas. The raw alphas

are measures of relative strength. In our case, our raw alphas are simply the log

of the ratio of price one month ago to price seven months ago. That is, they are

six-month log price relatives (or six-month formation period returns) calculated

using a one-month gap. The six-month period is consistent with most prior literature; the one-month gap is included to reduce the impact on prots of possible

short-term price reversals not caused by bid-ask bounce (we use mid-spread

prices). The literature suggests there was a short-term reversal in New Zealand

stocks at the weekly horizon in early data (Bowman and Iverson, 1998, using

19671986 data), but that it was absent at that horizon in later data (Boebel and

Carson, 2001, using 19911999 data).

These alphas are built to be benchmark neutral. In other words, holding the

benchmark exposes you to no ex-ante alpha and no active bets, but actively chasing these alphas goes hand-in-hand with actively stepping away from the benchmark. We then run an optimization routine each month to rebalance our

portfolio weights (the choice variables) by tilting them towards positive ex-ante

alphas and away from negative ex-ante alphas. We retard this alpha chasing by

including a penalty in our objective function that quanties the exposure to

active risk associated with actively stepping away from the benchmark. This

active risk is moderated using a client risk aversion coecient. We also include

penalties in our objective function for the transactions costs incurred by chasing

alpha (the objective function appears below in equation (1)). Our transactions

costs include the explicit cost associated with buying stocks at the ask and selling

them at the bid and also the implicit price impact incurred when we need to

walk up or down the centralized limit order book (CLOB) to ll a trade

thereby pushing prices against us (see Section 3.4, for details of our model of

price impact).

Although addressing the same question and using similar data, our approach

is in stark contrast to the approach of Gunasekarage and Kot (2007). They form

equally weighted long-short portfolios of winners and losers and then ex-post

use an ad hoc estimate of transactions costs. We, however, form optimally

1

An extended version of this paper is available from the authors upon request. It contains

a deeper discussion of the optimization and its constraints, the steps in the alpha construction, the variance-covariance matrix estimation, and the results. It also contains an explicit decomposition and attribution of momentum prots to industry and stock-specic

factors (the rst such for New Zealand).

2010 The Authors

Accounting and Finance 2010 AFAANZ

948

weighted portfolios, allow realistic underweighting that avoids shorting and use

realistic transactions costs using actual spreads and a practitioner model of price

impact.

Our approach also contrasts with Korajczyk and Sadka (2004), who use US

stocks. They form equal- or value-weighted portfolios of recent winners and then

account ex-post for the transactions costs needed to rebalance the portfolios each

month. They subsequently compute Sharpe ratios and (Jensen alpha type)

abnormal returns relative to the Fama-French three-factor model.

Although relatively standard, the Gunasekarage and Kot (2007) and

Korajczyk and Sadka (2004) techniques just described are both na ve implementations of an active trading strategy. Practitioners do not blindly chase anticipated returns and then passively account ex-post for the transactions costs and

risk; doing so is sub-optimal. Rather, practitioners weigh all three simultaneously: A portfolio manager may, for example, avoid overweighting a small

capitalization stock that has attractive momentum characteristics if it has high

transactions costs or unfavourable risk characteristics. Korajczyk and Sadka do

attempt to address this deciency by also using liquidity conscious portfolios

with weights that are related to the liquidity of the stock (Korajczyk and Sadka,

2004, pp. 1054, 1075), but they acknowledge that this approach to portfolio formation is optimal only under fairly restrictive conditions (Korajczyk and Sadka,

2004, p. 1054).

Like most quantitative active equity strategies, we try to avoid benchmark timing2 by constraining the ex-ante portfolio beta each month to equal 1 (in practice, we are rebalancing only once a month, so we incur some unintended

benchmark timing as the beta slips away from 1; we account for this in our performance measurement). We also constrain portfolio turnover each month, limit

the size of the active bets in any stock and require the portfolio to be fully

invested in equities. For the relatively unconstrained strategies, we allow short

selling, but ultimately our feasible strategies are all long only.

Korajczyk and Sadka choose to use long-only portfolios of winners. They

argue that this avoids the asymmetric costs associated with the short side of a

long-short strategy (Korajczyk and Sadka, 2004, p. 1045). Many other researchers (e.g. Chen et al., 2002; Gunasekarage and Kot, 2007) use long-short arbitrage

strategies. All these papers, however, overlook our tilts approach, where a passive benchmark fund is actively tilted towards over- and underweights, but without breaching the long-only constraint, and where the optimization takes care of

the transactions costs. Although not a true long-short fund, and although the

long-only constraint may carry a considerable impact (Grinold and Kahn,

2000a, Chapter 15; Grinold and Kahn, 2000b), our resulting long-only

2

Benchmark neutrality also reduces the likelihood that abnormal returns are generated

by any rm characteristics common to the rms in this small market. This is because, by

construction, the overweight/underweight nature of the active positions reduces exposure

to common rm characteristics.

2010 The Authors

Accounting and Finance 2010 AFAANZ

949

implementations allow consideration of both winners and losers and look like

standard institutional practice for a quantitative fund.

The choice variables in the optimization are the vector hP of holdings in the

portfolio of stocks that are members of the benchmark. The optimization is a

maximization of a value added (VA) objective function (Grinold and Kahn,

2000a, p. 119) modied for transactions costs. The objective function has the following form:

VA aP k x2P TC

of the portfolio holdings vector and the vector aP of ex-ante alphas for the individual stocks; k is the client risk aversion coecient; x2P r2P r2B

hP 0 VhP -hB 0 VhB is the forecast active risk of the portfolio (where B denotes

benchmark), where V is a variance-covariance matrix of returns; and TC is the

estimated transactions costs (including both actual spreads and estimated price

impact) associated with rebalancing the portfolio. Everything in this objective

function is scaled to be in annual return terms (see Section 3.4).

The portfolio is assumed to be launched at the end of June 1992, with benchmark weights (as if an active manager had just taken over a passive fund) and

with an initial investment ranging from $1 in the relatively unconstrained case

up to $150 million. At the end of each subsequent month, we examine our

existing holdings, and we rebalance by running the optimization to chase the

just-calculated ex-ante alphas by choosing new portfolio weights subject to

the above-mentioned penalties and constraints. We calculate gross returns over

the following month, calculate the new end-of-month dollar balance of the fund

and then we recalculate the ex-ante alphas and rebalance again (in all, we rebalance 171 times over our sample period). For each strategy, monthly turnover

was reassuringly credible and in line with our intuition (averages are reported

later in the paper). All strategies are self-nancing; no new money enters the

portfolios. For each gross return simulation, we also perform a separate net

return simulation, where monthly transactions costs are subtracted from the

gross return before calculating the new end-of-month dollar balance of the fund.

At each step, we ensure that all information used for the optimization was available to a portfolio manager at that date. When stocks enter or exit the index, we

temporarily increase the turnover allowance (as a function of the index weight of

the stock that is entering or exiting) to allow the manager to trade into or out of

the position quickly without breaching the turnover constraint. We run the

momentum trading strategy using dierent fund sizes, dierent ex-ante alpha

formation periods, with and without the one-month gap, dierent client risk

aversion coecients, dierent allowances for turnover, dierent allowances for

active weight and with and without short selling. The results are discussed in

Section 4, below.

2010 The Authors

Accounting and Finance 2010 AFAANZ

950

Our optimization uses a transactions cost penalty in the objective function

given by TC = 12 hP 0 (RS + PI) calculated as 12 times the inner product of

the portfolio holdings vector hP and the sum of the vectors RS and PI, which are

described below. In practice, fund managers using this technique rebalance more

frequently than monthly, but otherwise our model of transactions costs is used

by practitioners in essentially the same way that we use it here (Grinold and

Kahn, 2000a).

The terms RS and PI are vectors whose elements contain the relative spread,

RSi, and price impact, PIi, functions for each stock i. These stock-specic

functions are estimated as follows (Grinold and Kahn, 2000a, p. 452):

RSi

1

ask bid

h i;t hi;t

2

bid ask=2

s

volumetrade

PIi

rdaily

volumedaily

where h*i,t is the new optimal portfolio holding of stock i at time t, and hi,t is the

existing holding of stock i at time t immediately before the rebalance, bid and

ask represent the current bid and ask prices for stock i (subscript suppressed),

volumetrade denotes the number of shares required to be traded to reach the new

portfolio holding of stock i, volumedaily represents the average daily volume of

stock i for the past 40 trading days (split adjusted) and rdaily is the past 250-day

standard deviation of daily returns to stock i (subscript suppressed on the righthand side of equation (3)). To avoid confusion, note that hi,t, the existing holding

in stock i just prior to the rebalance, is what h*i,t)1 (the most recent rebalanced

optimal holding) has evolved into over the months time period t)1 to t.

Korajczyk and Sadka (2004) calibrate their price impact models explicitly

using US TAQ data. Without intraday data we have instead used, in equation

(3), an implicit scaling based on the traders rule of thumb that it costs approximately one days volatility to trade one days volume (Grinold and Kahn, 2000a,

p. 452). Note that Korajczyk and Sadka use academic models of price impact

(e.g. Glosten and Harris, 1988; Breen et al., 2002), whereas we use a model of

price impact taken directly from the practitioner literature (Grinold and Kahn,

2000a, p. 452).

Like Glosten and Harris (1988), our model of transactions costs for a given

stock is composed of a cost that is xed as a function of volume traded by the

strategy (i.e. the relative spread) and a cost that is a variable function of volume

traded by the strategy (i.e. the price impact). Equation (3) says that we are

2010 The Authors

Accounting and Finance 2010 AFAANZ

951

modelling the percentage price impact (i.e. as a percentage of initial stock price)

as a square root function of the number of shares traded by the strategy (in that

stock during that month). This square root form has its foundation in Barra

research that analysed Loeb (1983) and found the results consistent with a

square root pattern (see Grinold and Kahn, 2000a, p. 452). This square root

form is clearly a concave functional form, and it gives immediately a concave

functional form for percentage price impact as a function of dollar volume of the

strategy in that stock.

Loeb (1983), Glosten and Harris (1988), Hausman et al. (1992), Keim and

Madhavan (1996) and Breen et al. (2002) all present theoretical models and/or

empirical results that are consistent with a percentage price impact function that

is, like ours, concave when price impact as a percentage (of original price or of

portfolio value) is expressed in terms of dollar volume. Hasbrouck (1991) presents a price impact model but the functional form for percentage price impact

as a function of dollar volume is not clear.

Although concave when expressed as percentage price impact as a function of

dollar volume, if we multiply both sides of (3) by dollar volume, to look at total

absolute price impact cost (in dollars) as a function of dollar volume, the resulting convex functional form involves dollar volume to the power of 3/2 (Grinold

and Kahn, 2000a, p. 452).

Finally, the annualized transactions cost is the cost of a trade divided by the

rebalance period in years. Therefore, we scale the transactions costs by a factor

of 12 in the objective function.

3.5. Testing for the existence of momentum prots

Our simulated portfolio strategy generates a time series of 171 months of portfolio gross returns, portfolio returns net of transactions costs and benchmark

returns. Momentum prots can be tested for with the following regression:

rP;t rf;t aP bP rB;t rf;t et

where rP,t denotes the realized monthly return on the active portfolio at time t,

rf,t is the monthly risk-free rate of return, rB,t is the realized monthly benchmark

^ is the realized portfolio beta

return, ^

aP is the ex-post realized monthly alpha, b

P

^

and ^et rP;t rf;t ^

aP bP rB;t rf;t is the realized residual return. Simple

returns are used for the regression and appear for all reported results. When

portfolio gross returns (i.e. ignoring any transactions costs) are used in (4), aP is

a risk-adjusted measure of exceptional performance, and we can measure its statistical signicance with the standard t-statistic. When portfolio returns net of

transactions costs are used in (4), aP is a risk-adjusted and transactions costadjusted measure of exceptional performance. Risk-adjusted here means that

the alpha was harvested from returns earned by a portfolio that was formed

Accounting and Finance 2010 AFAANZ

952

using an objective function that included an explicit penalty for risk, and also

that the regression equation removes the portion of portfolio return associated

with the benchmark. The realized ex-post alpha thus accounts for client risk

aversion and benchmark riskwhich are, ultimately, what matter to clients of

institutional asset managers.

4. Results

4.1. The protability of price momentum

Our relatively unconstrained portfolio is designed to be analogous to the

unconstrained strategies reported in the literature, such as Gunasekarage and

Kot (2007). It has an initial investment of $1 and is allowed to short sell, take

active weights of 20 per cent (this is the maximum allowed value of any element

of the vector jhP hB j in any month) and have a maximum two-sided turnover

of 50 per cent per month. We include penalties for the bid-ask spread and price

impact in the objective function, but the tiny $1 portfolio size means that the

price impact is eectively zero.

Figure 1 and Table 2 provide strong evidence of a momentum eect with

mean monthly returns well in excess of the mean monthly benchmark return and

signicant levels of alpha (i.e. realized abnormal return as in equation (4)) at the

0.1 per cent level for the gross returns and the 1 per cent level for the net returns.

The relatively unconstrained portfolio produces a gross alpha of 112 bps per

month before subtracting transactions costscomparable with Gunasekarage

and Kot (2007). This strategy is, however, not realistic because a larger fund

would push prices against it as it walks up or down the CLOB. Also, although

short selling is allowed in New Zealand, it is not widely used. Finally, the strategy pushes the two-sided turnover constraint of 50 per cent to the limit every

time the portfolio is rebalanced. This indicates that the returns will be severely

decreased once price impact is considered and turnover is properly constrained.

Net of transactions costs (eectively the relative spread only in this case), the relatively unconstrained portfolio still produces a monthly alpha of 87 bps per

month and a good information ratio (i.e. Sharpe ratio calculated using residual

returns) of IR = 0.67.

The last two rows of Table 2 show that removing the ability to short and tightening the turnover and active weight constraints immediately kills o more than

three-quarters of the realized alpha; the IR on the constrained $1 portfolio is still

good, however, and is 0.47 after transactions costs.

In all portfolios reported in Table 2, unintentional benchmark timing caused a

slight decrease in portfolio return. We constrained our ex-ante portfolio beta to

equal 1 when we rebalanced each month, but in a real-world trading strategy,

the portfolio managers would rebalance something like 10 times per month

(whenever exposure to the recalculated ex-ante alphas falls far enough to warrant

the transactions costs of a rebalance). Our monthly rebalance is infrequent

2010 The Authors

Accounting and Finance 2010 AFAANZ

Cumulative level

1900

1800

1700

1600

1500

1400

1300

1200

1100

1000

900

800

700

600

500

400

300

200

100

0

Jun-1992

953

$1 Portfolio, relatively unconstrained, net return

$1 Portfolio, constrained, gross return

$1 Portfolio, constrained, net return

Benchmark (NZSE40/NZX50)

Jun-1994

May-1996

May-1998

May-2000

May-2002

May-2004

May-2006

All portfolios are momentum strategies with an initial fund value of $1. The relatively unconstrained portfolios are allowed to short sell and

have a maximum turnover of 50 per cent, and a maximum active weight of 20 per cent. The constrained portfolios are not allowed to short sell and have a

maximum turnover of 20 per cent and a maximum active weight of 5 per cent. Gross return refers to the estimated portfolio return prior to transaction costs.

Net return refers to the estimated portfolio return after transaction costs (i.e. spreads and price impact).

enough that our portfolio betas slip away from 1, which introduces unintentional

benchmark timing. We focus on the ex-post alpha ^aP rather than on the active

return

rP

rB because the alpha represents the intentional return to stock selection, whereas the active return includes the unintentional benchmark timing

return.

Table 3 reports the results for trading strategies where we have estimated a

more realistic portfolio than in Table 2. Each of these strategies was implemented with a $100 million initial portfolio, no short selling, an active weight

constraint of 5 per cent and a two-sided turnover constraint of 20 per cent per

month. We also report strategies with dierent ex-ante alpha constructions (with

and without a one-month gap and using three or six months for the formation

period).

Although the mean gross return to the realistic portfolios in Panel A and Panel

B of Table 3 exceeds the mean return to the benchmark, we see that without

exception the gross alphas are economically small and statistically insignicant,

and the net alphas are statistically signicantly negative at the 0.1 per cent level.

The benets of stepping away from the benchmark have therefore failed to

exceed the cost of doing so. Real-world constraints mean that we have not been

able to capture the promising momentum prots we saw in the relatively unconstrained portfolios in Table 2.

An asterisk in Table 3 marks our base portfolio. In the remainder of the

paper, we vary its characteristics/constraints to deduce which are pivotal in

destroying the prots we saw in the relatively unconstrained case.

2010 The Authors

Accounting and Finance 2010 AFAANZ

Accounting and Finance 2010 AFAANZ

171

171

171

171

171

Benchmark

Rel. Unconstrained, Gross Return

Rel. Unconstrained, Net Return

Constrained, Gross Return

Constrained, Net Return

0.78%

1.85%

1.60%

1.00%

0.94%

0.04460

0.05601

0.05662

0.04305

0.04297

StdDev of

Returns

1.12%

0.87%

0.24%

0.18%

Alpha

3.29

2.54

2.33

1.76

Alpha

t-value

0.770

0.781

0.918

0.918

Beta

)0.230

)0.219

)0.082

)0.082

Active

Beta

)0.05%

)0.05%

)0.02%

)0.02%

Bmark

Timing

Return

0.87

0.67

0.62

0.47

Resid.

IR

0.376

0.378

0.905

0.908

R2

101.7

102.8

1611.0

1666.8

F

Stat

All estimates are monthly. N is the number of monthly rebalances. All portfolios have a six-month formation period, with a one-month gap prior to the

holding period. The relatively unconstrained portfolios are allowed to short sell and have a maximum turnover of 50 per cent and a maximum active weight

of 20 per cent. The constrained portfolios are not allowed to short sell and have a maximum turnover of 20 per cent and a maximum active weight of 5 per

cent. All portfolios have an initial value of $1. Gross return refers to the estimated portfolio return prior to transaction costs. Net return refers to the estimated portfolio return after transaction costs (i.e. spreads and price impact). All portfolios were constrained to have ex-ante beta of 1 at each monthly rebalance. All F-Stats are signicant at better than 1 per cent.

Portfolio

Mean

Return

Table 2

Relatively unconstrained return momentum strategies

954

S. Trethewey, T. F. Crack/Accounting and Finance 50 (2010) 941965

Accounting and Finance 2010 AFAANZ

0.04460

0.04309

0.04441

0.04362

0.04363

0.04360

0.04342

0.04298

0.04369

0.04298

0.04383

0.04369

0.82%

0.49%

0.84%

0.50%

0.80%

0.45%

0.80%

0.52%

0.80%

0.78%

0.52%

StdDev of

Returns

0.78%

Mean

Return

0.60

0.05

)3.84

)0.25%

0.53

)5.37

0.60

)3.84

0.87

)4.46

1.20

)4.25

0.03%

0.00%

0.03%

)0.32%

0.03%

)0.25%

0.05%

)0.29%

0.07%

)0.27%

Alpha

Alpha

t-value

0.961

0.949

0.969

0.962

0.958

0.949

0.961

0.951

0.977

0.962

0.960

Beta

)0.01%

)0.01%

)0.051

)0.031

)0.01%

)0.01%

)0.01%

)0.01%

)0.01%

)0.038

)0.042

)0.051

)0.039

)0.039

)0.01%

)0.01%

)0.01%

)0.01%

Bmark

Timing

Return

)0.049

)0.023

)0.038

)0.040

Active

Beta

)1.02

0.16

0.01

0.14

)1.42

0.16

)1.02

0.23

)1.18

0.32

)1.13

Resid. IR

0.962

0.970

0.972

0.969

0.969

0.970

0.962

0.969

0.964

0.967

0.964

R2

4270.3

5539.8

5807.4

5224.1

5222.1

5539.8

4270.3

5299.4

4541.2

5021.0

4565.1

F

Stat

All estimates are monthly. N is the number of monthly rebalances. No gap refers to immediate investment after the formation period. All portfolios have

an initial value of $100 million, maximum turnover of 20 per cent and maximum active weight of 5 per cent. One-month gap refers to leaving a one-month

gap between the formation and holding period to remove any potential reversal eects. The number of rebalances indicates the length in months of the strategy formation period. Gross return refers to the estimated portfolio return prior to transactions costs. Net return refers to the estimated portfolio return after

transaction costs. Gross return less relative spread refers to the estimated portfolio return after the relative spread transactions costs have been removed, but

before the price impact costs have been removed. All F-Stats are signicant at better than 1 per cent.

*The base portfolio: initial value of $100 million, 20 per cent maximum turnover, 5 per cent maximum active weight, full objective function, six-month formation period and one-month gap until holding period. This portfolio is used for comparison throughout the results.

Benchmark

171

Panel A: No gap

3-Month, Gross Return

171

3-Month, Net Return

171

6-Month, Gross Return

171

6-Month, Net Return

171

Panel B: One-month gap

3-Month, Gross Return

171

3-Month, Net Return

171

6-Month, Gross Return*

171

6-Month, Net Return

171

Panel C: The eect of transactions costs

6-Month, Gross Return*

171

6-Month, Gross Return

171

less Relative Spread

6-Month, Net Return

171

Formation-Return

Combination

Table 3

Transactions costs and the protability of return momentum strategies

955

956

375

350

$100m base portfolio, gross return

325

Cumulative level

300

275

Benchmark (NZSE40/NZX50)

250

225

200

175

150

125

100

75

Jun-1992

Jun-1994

May-1996

May-1998

May-2000

May-2002

May-2004

May-2006

All portfolios are momentum strategies that are variations, by transaction costs only, of the base portfolio*. Gross return refers to the estimated portfolio return

prior to transaction costs. Net return refers to the estimated portfolio return after transaction costs (i.e. spreads and price impact). Gross return less relative spread

refers to the estimated portfolio return after the relative spread transaction costs have been removed. *The base portfolio: initial value of $100 million, 20 per cent

maximum turnover, 5 per cent maximum active weight, full objective function, six-month formation period and one-month gap until holding period.

Figure 2 and Panel C of Table 3 demonstrate that deducting the spread component of transactions costs from the gross $100 million base portfolio return

causes the strategy to match the returns of the benchmark within rounding error.

Then, subsequently removing the price impact transaction cost causes the strategy to signicantly underperform the benchmark.

Momentum trading strategies are designed to exploit short-lived eects. It

is not surprising, therefore, that they are reported to have high turnover

(Keim, 2003; Lesmond et al., 2004; Sadka, 2006). For the $100 million base

portfolio, the mean two-sided turnover was 127 per cent per annum, but it

was 697 per cent per annum in the relatively unconstrained portfolio. These

turnovers correspond to average stock holding periods of 9.4 and 1.7 months,

respectively. The shorter holding period brings with it greater momentum

prots (as seen here and in Gunasekarage and Kot, 2007), but the portfolio

turnover required to achieve a short holding period in the base portfolio

involves an infeasible amount of price impact. Although the mean transaction

cost attributable to the spread component was only 5 bps per month, the

mean transaction cost attributable to price impact was 28 bps per month.

Price impact thus accounts for 85 per cent of the transactions costs of the

strategy and cannot be ignored.

Korajczyk and Sadka (2004) also discuss the size of spread and price impact

components of transactions costs for stand-alone momentum strategies, but

they do not explicitly identify the relative sizes of these components. We

deduce that their spread component of transactions costs is in the range of

2010 The Authors

Accounting and Finance 2010 AFAANZ

957

1245 bps per month, depending upon portfolio formation strategy (Korajczyk

and Sadka, 2004, p. 1058). We deduce that their price impact transactions

costs in a USD 5 billion portfolio are in the range 40100 bps per month for

the value- and liquidity-weighted strategies; the particular values in these

ranges depend upon the portfolio formation strategy and the model of price

impact (Korajczyk and Sadka, 2004, Figures 4(a), 5(a), 6(a) and 7(a)). We conclude that their price impact component of transactions costs is, like ours, the

largest part of the transactions costs for any reasonably sized strategy. It is

hardly surprising that their transactions costs are noticeably larger than ours

in absolute magnitude (twice or more), because our optimization includes an

explicit transactions costs penalty in the objective, which means that, like a

practitioners, our portfolios are chosen specically so as to minimize exposure

to stocks with higher transactions costs.

In our implementation, we trade only once per month. We may, therefore, be

overestimating practitioner price impact as a function of dollar volume. Figure 2

and Panel C of Table 3 show, however, that even if price impact were zero, the

base portfolios performance still only matches that of the benchmark. On the

returns side, however, our infrequent rebalancing may lose exposure to ex-ante

alphas, and we may therefore underestimate the ability of the model to gain traction with our alphas.

4.2. The impact of relative spreads and fund size

Table 4 reports estimates of the eects of dierent assumed relative spreads

(Panel A) and initial fund sizes (Panel B) on the performance of the momentum

strategy. All portfolios are compared with our base portfolio and the full form

of the objective function is used.

The results in Panel A of Table 4 show that the mean returns per month of the

momentum strategy are very stable across the variations of relative spread.

Using a blanket 80 bps relative spread for all stocks generates a higher mean

return on a gross and net basis. The performance using the 80 bps spread is only

marginally higher than the performance using a minimum 50 bps spread and

slightly higher again than using actual spreads.

In Panel B of Table 4, all portfolios considered are variations of the base portfolio, with only the initial fund value changing. We can see the alpha and the IR

dropping almost monotonically as the fund size increases and the price impact

begins to bite. The $1 portfolio, with eectively no price impact, predictably produces the highest mean return and a gross alpha of 24 bps per month (the net

alpha for this strategy appeared in Table 2 and was a respectable 18 bps per

month). The eect of the price impact function is not noticeable until the fund

size reaches $10 million. In fund sizes above $50 million, we observe that the

price impact function signicantly retards the strategy from trading in stocks

that produce good alpha.

Accounting and Finance 2010 AFAANZ

Accounting and Finance 2010 AFAANZ

0.04460

0.04343

0.04297

0.04440

0.04345

0.04298

0.04369

0.04305

0.04283

0.04265

0.04311

0.04298

0.04438

0.78%

0.86%

0.52%

0.82%

0.52%

0.80%

0.52%

1.00%

0.97%

0.90%

0.82%

0.80%

0.84%

StdDev of

Returns

0.24%

0.21%

0.14%

0.05%

0.03%

0.07%

2.33

2.48

2.02

0.80

0.60

1.13

0.60

)3.84

)3.97

)0.25%

0.03%

)0.25%

1.53

)4.00

0.69

0.09%

)0.25%

0.04%

Alpha

Alpha

t-value

0.918

0.928

0.936

0.952

0.949

0.980

0.949

0.961

0.956

0.959

0.946

0.982

Beta

)0.01%

)0.01%

)0.01%

)0.02%

)0.02%

)0.02%

)0.01%

)0.01%

0.00%

)0.051

)0.039

)0.082

)0.072

)0.064

)0.048

)0.051

)0.020

)0.01%

)0.01%

0.00%

Bmark

Timing

Return

)0.044

)0.041

)0.054

)0.018

Active

Beta

0.62

0.66

0.54

0.21

0.16

0.30

0.16

)1.02

)1.05

0.41

)1.06

0.18

Resid.

IR

0.905

0.934

0.958

0.970

0.970

0.970

0.970

0.962

0.964

0.971

0.964

0.973

R2

1611.0

2377.6

3827.4

5457.2

5539.8

5500.0

5539.8

4270.3

4461.8

5645.8

4528.4

6034.9

F

Stat

All estimates are monthly. N is the number of monthly rebalances. All portfolios have a maximum turnover of 20 per cent and maximum active weight of 5

per cent. Panel A contains variations on the relative spread. 80 bps spread refers to all stocks having their relative spread set to a blanket 80 bps. Minimum

50 bps spread refers to all stocks having actual spreads overlaid with a minimum relative spread of 50 bps. Actual spread indicates that the reported bid-ask

spread has been used to calculate the relative spread. All portfolios in Panel A had an initial value of $100 million. Panel B contains variations of the portfolio size by gross returns. Gross return refers to the estimated portfolio return prior to transaction costs. Net return refers to the estimated portfolio return

after transaction costs (i.e. spreads and price impact). All F-Stats are signicant at better than 1 per cent.

*The base portfolio: initial value of $100 million, 20 per cent maximum turnover, 5 per cent maximum active weight, full objective function, six-month formation period and one-month gap until holding period.

Benchmark

171

Panel A: Relative spreads

80 bps spread, Gross Return

171

80 bps spread, Net Return

171

Minimum 50 bps spread,

171

Gross Return

Minimum 50 bps spread,

171

Net Return

Actual spread, Gross Return*

171

Actual spread, Net Return

171

Panel B: Fund size (all gross returns)

$1

171

$1 million

171

$10 million

171

$50 million

171

$100 million*

171

$150 million

171

Portfolio

Mean

Return

Table 4

The eect of relative spreads and fund size on the protability of return momentum strategies

958

S. Trethewey, T. F. Crack/Accounting and Finance 50 (2010) 941965

959

Table 5 reports the impact on our base portfolios performance when we vary

the components of the objective function (Panel A and Panel B) or the tightness

of the turnover or active weight constraints (Panels C and Panel D).

Grinold and Kahn (2000a, p. 119) quote high (k 15), moderate (k 10) and

low (k 5) values for client risk aversion. Panel A of Table 5 indicates that,

other things being equal, the tight limits on active weights and turnover and the

presence of the price impact penalty term in the objective function, combined

with the inability to short sell, retard portfolio trade to the extent that the risk

aversion is simply not biting in their presence.

Panel B of Table 5 explores dropping various terms from the full objective

function for the base portfolio. We see that dropping the price impact penalty

in the objective function immediately adds 21 bps per month to the gross

alpha (but unsurprisingly this change destroys approximately 100 bps of net

alpha per month; not reported in the tables). Then, dropping the spread component from the objective function adds an additional 9 bps per month to the

gross alpha. Then, dropping the risk aversion component adds just one more

basis point to the gross alpha but hurts the IR because of the additional active

risk taken on.

Looking at Panels C and D of Table 5, we can see that relaxing the turnover

and active weight constraints has only a slight eect on gross returns unless the

price impact penalty term in the objective is removed, in which case the eect on

gross alpha is signicant, jumping by 27 bps per month (but again unsurprisingly

this change destroys approximately 200 bps of net alpha per month; not reported

in the tables). Then also dropping the risk aversion down to k 5 has only a

marginal impact on alpha but again hurts the IR through additional active risk

taken on. The implication is that the price impact and risk aversion penalty

terms are important for retarding alpha chasing that would otherwise be blind to

transactions costs or active risk, respectively.

4.4. Market capitalization, winners, losers and shorts

Ignoring transactions costs, the small capitalization holdings of our base

portfolio generate 50 bps of alpha per month (compared with 30 bps of alpha

generated per month by their na ve sub-index portfolio).3 The large capitalization holdings of the base portfolio lose 24 bps of alpha per month (roughly

matching their sub-index portfolio). These results are consistent with Lesmond

et al. (2004), who nd that the stocks that generate large momentum returns

are precisely those stocks with high trading costs. No wonder we found that

Full details of the return attributions in this section are available from the authors upon

request.

2010 The Authors

Accounting and Finance 2010 AFAANZ

Benchmark

171

0.78%

Panel A: Risk aversion

Lambda = 5

171

0.85%

Lambda = 10*

171

0.80%

Lambda = 15

171

0.83%

Panel B: Objective function

Active Return

171

1.09%

Active Return and Active Risk

171

1.09%

Active Return, Active Risk, and

171

1.00%

Relative Spreads

Active Return, Active Risk, and Full

171

0.80%

Transactions Costs*

Panel C: Constraint levels

Turnover 50%, Active Weight 5%

171

0.80%

Turnover 20%, Active Weight 5%*

171

0.80%

Turnover 10%, Active Weight 5%

171

0.84%

Turnover 20%, Active Weight 10%

171

0.83%

Turnover 20%, Active Weight 20%

171

0.87%

Panel D: Variations on base portfolio constraints and penalties

Turnover 20%, Active Weight 5%*

171

0.80%

Turnover 50%, Active Weight 20%

171

0.82%

Turnover 50%, Active Weight 20%,

171

1.06%

No PI in Obj. Fn.

Portfolio

Mean

Return

0.08%

0.03%

0.05%

0.34%

0.33%

0.24%

0.03%

0.03%

0.03%

0.07%

0.06%

0.10%

0.03%

0.04%

0.31%

0.04301

0.04316

0.04306

0.04298

0.04317

0.04298

0.04351

0.04282

0.04374

0.04298

0.04349

0.04327

Alpha

0.04344

0.04298

0.04389

0.04460

StdDev of

Returns

Accounting and Finance 2010 AFAANZ

0.60

0.70

2.14

0.58

0.60

1.08

0.96

1.46

0.60

2.69

3.13

2.35

1.36

0.60

0.95

Alpha

t-value

0.949

0.957

0.873

0.954

0.949

0.958

0.943

0.961

0.949

0.892

0.919

0.918

0.958

0.949

0.971

Beta

)0.01%

)0.01%

)0.01%

)0.03%

)0.02%

)0.02%

)0.01%

)0.01%

)0.01%

)0.01%

)0.01%

)0.01%

)0.01%

)0.01%

)0.03%

)0.108

)0.081

)0.082

)0.051

)0.046

)0.051

)0.042

)0.057

)0.039

)0.051

)0.043

)0.127

Bmark

Timing

Return

)0.042

)0.051

)0.029

Active

Beta

Table 5

The eect of the optimisation parameters on the protability of return momentum strategies (all gross returns)

0.16

0.19

0.57

0.15

0.16

0.29

0.25

0.39

0.16

0.71

0.83

0.62

0.36

0.16

0.25

Resid.

IR

0.970

0.964

0.808

0.972

0.970

0.964

0.965

0.961

0.970

0.856

0.902

0.905

0.968

0.970

0.974

R2

5539.8

4551.8

710.9

5871.4

5539.8

4512.8

4722.5

4124.4

5539.8

1004.9

1547.5

1607.3

5140.7

5539.8

6455.2

F

Stat

960

S. Trethewey, T. F. Crack/Accounting and Finance 50 (2010) 941965

Accounting and Finance 2010 AFAANZ

171

N

1.07%

Mean

Return

0.04486

StdDev of

Returns

0.32%

Alpha

1.75

Alpha

t-value

0.850

Beta

Bmark

Timing

Return

)0.04%

Active

Beta

)0.150

0.47

Resid.

IR

0.713

R2

420.5

F

Stat

All estimates are monthly. N is the number of monthly rebalances. All portfolios have an initial value of $100 million and are gross return variants of the

base portfolio* with the specied parameters altered. Within Panel A, lambda is the client risk aversion coecient used in the objective function. Higher levels of lambda represent greater risk aversion. The levels of risk aversion where chosen following Grinold and Kahn (2000a, p. 119). In Panel B, the portfolios

refer to variations on the form of the objective function. Full transactions costs is the sum of relative spreads and price impact costs. Within Panel C, the constraint levels represent the maximum level of active weight or turnover that the portfolio may have each time it is rebalanced. The portfolios in Panel D are

variations on the base portfolio with changes in the constraints and the objective function penalties (PI refers to price impact). All F-Stats are signicant at

better than 1 per cent.

*The base portfolio: initial value of $100 million, 20 per cent maximum turnover, 5 per cent maximum active weight, full objective function, six-month formation period and one-month gap until holding period.

No PI in Obj. Fn.,

Lambda = 5

Portfolio

Table 5 (continued)

961

962

the price impact term is so biting, given that price impact is greater in small

stocks and that it is the small stocks that are providing the ex-post alpha performance.

Again, ignoring transactions costs, the winner (i.e. overweight) sub-portfolio

of our base portfolio generates 20 bps of alpha per month (compared with

14 bps of alpha generated by its na ve sub-index portfolio), but the loser (i.e.

underweight) sub-portfolio loses 32 bps of alpha per month (compared with

13 bps of alpha lost by its na ve sub-index portfolio). In the relatively unconstrained portfolio, however, winners generate 36 bps of alpha per month (compared with 8 bps of alpha generated by their sub-index, losers (underweight but

not short) roughly match their sub-index, and shorts generate 46 bps of alpha

more per month than the )3 bps provided by their sub-index portfolio. The

short constraint in the base portfolio thus confounds the ability of the optimizer

to correctly weight the underachievers, and, by doing so, confounds the ability

for the optimizer to correctly exploit the winners (see related discussion in

Grinold and Kahn, 2000a, p. 421 and Grinold and Kahn, 2000b).

The importance of the short position here is also consistent with earlier literature that nds that stock prices are more likely to underreact to bad news

than to good news (Hong et al., 2000, p. 277), and, as such, the ability to

short the losers is very valuable. Similarly, Lee and Swaminathan (2000, Table

I) and Lesmond et al. (2004, Table 1) nd that portfolios of loser stocks subsequently underperform average stocks by more than winner stocks outperform

them.

Gunasekarage and Kot (2007, p. 120) consider long-only portfolios, and they

also nd that the winners are driving the momentum prots. In contrast to us,

however, they say that it is the larger capitalization stocks that generate alpha.

They have a much broader sample of stocks than ours, and our small stocks

probably account for half of their large stocks, while our large stocks have no

impact at all.

If we were to trade only the highly liquid stocks, we could reduce the liquidity

problems and minimize price impact. This is what Stork (2008) does, with

reported protability before transactions costs. Unfortunately, concentrated

portfolios of only a few stocks are not attractive to institutional asset managers.

The active risk is simply too high, and, if implemented in any size, price impact

would again become an issue. On top of these problems, our analysis indicates

that the momentum prots are predominantly sourced in the smaller capitalization stocks. For all these reasons, we believe a concentrated high-liquidity strategy is not feasible.

Although the net returns to all of our realistic portfolios are negative, the

momentum strategy may be useful as one of a group of alpha signals implemented simultaneously, or as a trade timing indicatorwhen you have to get

a trade completed and want to know whether you should wait to execute it or

not.

Accounting and Finance 2010 AFAANZ

963

5. Conclusion

We test whether recently reported prots from price momentum trading strategies in the New Zealand stock market (Gunasekarage and Kot, 2007; Stork,

2008) are able to be captured using a simulated portfolio trading strategy. Within

the NZSE40/NZX50 index, the smaller stocks generate gross momentum prots,

but have high spreads and low turnover; the low turnover, in turn, implies high

price impact. In a tiny unconstrained portfolio, smaller stocks, winner stocks

and shorts combine to generate gross performance so exceptional that performance net of spreads is excellent (and price impact is negligible). In a portfolio

of any size and with short sale constraints, however, transactions cost avoidance

and risk aversion necessarily retard trade in the smaller stocks, winner stocks

provide no prots and shorts are unavailable. In this case, the trading strategy

still steps away from the benchmark to chase anticipated momentum prots, but

gross returns are less than anticipated and only just cover bid-ask spread costs;

portfolio size combined with high turnover in small stocks means that once price

impact is accounted for, performance lags the index. A proper accounting

for transactions costs and risk has therefore reversed the nding of the earlier literature.

A particular strength of our analysis is the introduction of a practitioner technique (quantitative active equity alpha optimization) for optimal portfolio rebalancing subject to risk and transactions costs. This technique is broadly

applicable to simulated trading strategies, but we have not seen it used elsewhere

in the academic literature.

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