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Momentum; ETFs; Portfolio Theory; Empirical Research

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Abstract We analyze the performance of a proprietary momentum model and accompanying 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 nd that our model does outperform the traditional momentum model across all strategy variation. However, both models underperform a simple Buy & Hold strategy for the assets and time period selected. In addition to these results, we introduce a dynamic threshold algorithm that determines ex ante the number of stocks to include in a portfolio. The results from this algorithm show that it is able to capture most of the risk-reward prole of the optimal portfolio.

Introduction

Momentum has historically possessed strong explanatory power within an asset pricing framework. Jegadeesh & Titman (1993) look at the performance of stock portfolios formed on a momentum rank, sometimes called cross-sectional or relative momentum, and nd statistically signicant positive performance even when controlling for systemic and other risk factors. Specically they nd that historic time frames of a year, the formation period, in conjunction with a holding period of three-to-twelve months yield superior results. This extended 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 discussed in Kahneman & Tversky (1982). Chan et al (1996) nd that portfolios of US stocks formed based upon returns for the past six months provide economically meaningful returns over the next six months. In addition, these returns are not highly correlated with returns of portfolios formed based upon earnings momentum. They go on to oer several theories for price momentum including under-reaction to past information, but refute theories associated with a positive-feedback mechanism. Cahart (1997) documents the presence of a momentum factor in addition to the traditional Fama-French 3-Factor model, in explaining the returns of portfolios of mutual funds. However, he goes on to state that based upon the data it appears that the presence of this explanatory factor is due to managers holding onto winning

Correspondence: rtsamuel3@gmail.com

stocks and not an attempt to prot from momentum strategies. Rouwenhorst (1998) looks at the performance of momentum in international markets and nd evidence that portfolios constructed 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 and nd for the period of 1990-1998 that portfolios with a positive momentum factor loading outperform those with a negative factor loading for up to twelve months after the formation period. In addition they look at the performance up to sixty months after formation and nd a reversal which repudiates the claims of other authors that momentum is a measurement of the unconditional expectation of returns. This revelation adds credence to behavioral theories which postulate that momentum is due to under/over-reaction to information by trading agents. Fama & French (2012) analyzed the performance of the four-factor model in explaining the excess returns of stocks globally and found that ex-Japan, momentum was a strong explanatory factor. Baltas & Kosowski (2012) look at time-series, or absolute, momentum with futures and again nd statistically signicant performance for the one year time frame in conjunction with a one month holding period. Moskowitz et al (2012) also look at time-series momentum using excess returns and nd statistically signicant positive returns 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 factor yielded superior returns to just forming portfolios immediately after calculation. Lastly, Antonacci (2013) nds that combining cross-sectional and absolute momentum yields superior results when utilized upon dierent asset classes. Given the breadth of literature that documents the presence of a momentum factor within nancial asset returns, we strive to develop a momentum model that encapsulates this empirical research. In the following sections we will cover the assets to be tested, the method of testing and a discussion of the results1 .

Data

We use daily Open, High, Low, Close, Adjusted Close, Volume and Dividend data from Yahoo! Finance for the ETFs listed in Table 12 . We employ ETFs for our analysis primarily to avoid having to establish point-in-time constituent members of a set of assets which would normally lead to survivorship bias3 . For a cash balance reference rate we use the Daily Eective Fed Funds Rate and for a risk-free rate we use the 3-Month Treasury Bill: Secondary Market Rate both from the from the St. Louis Federal Reserve Economic Database (FRED)4

Upon request, we can furnish an addendum which lists the tests, and statistics, along with their implementation. 2 Data from http://nance.yahoo.com/. 3 Survivorship Bias is the phenomena where a historic analysis is done on the current set of assets whose membership in that set are inuenced by their relative performance to other assets. In these scenarios the simulated performance of a strategy may be inuenced if the current set is used and not a point-in-time membership. 4 Data from http://research.stlouisfed.org/fred2/series/DFF and http://research.stlouisfed.org/fred2/series/DTB3 respectively. In regards to the 3-Month Bill rate there were twenty-four days with no data due to Columbus Day and Veterans Day. In this case we used an estimate for that days rate, Xt , using the time-series

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with descriptive statistics found in Table 2. In Table 3 we can see descriptive statistics on the adjusted daily closing prices for the specied ETFs5 . Jarque & Bera (1987) developed a Lagrange Multiplies statistic to test for non-normality using the sample skewness and sample kurtosis and looking at our price series we see that we reject the null hypothesis of normality for all series. In addition, Ljung & Box (1978) developed a portmanteau test to determine if the observations within a time series are independent by looking at lagged values and we see that for all of our price series that the null hypothesis is rejected for a specied lag of 1. In Table 4 we list the descriptive statistics for the returns, using the convention of rt = log (Pt ) log (Pt1 ), for adjusted closing prices. Mandelbrot (1963) documented the non-normality exhibited in lognormal price changes for nancial data, and we can clearly see that all of the series exhibit non-normality. In addition, most reject the null hypothesis of independence. Bollerslev (1986) developed an extension of the the Autoregressive Conditional Heteroscedascity (ARCH) which he termed General ARCH (GARCH) that tests for conditional changes in the variances. In our table we see that all of series follow a GARCH process with a statistically signicant ARCH process as well. Chow & Denning (1993) proposed a multiple variance test to test the null hypothesis that a time-series was a random walk. Given our evidence of heteroscedascity in all of the data series, we focus on the M V2 statistic they developed and see that for more than half of our data series we can reject the null hypothesis of a random walk series. This is signicant in that when our models identify 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 same distribution, and although we do not report it, the test failed to reject the null hypothesis and therefore there is insucient evidence to conclude that any of the returns come from a dierent distribution than the others.

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3.1

Model

We develop a momentum model, denoted as MM, which attempts to quantify the strength of a trend by outputting a real value number using three parameter values which determine the appropriate historical time period and smoothness of the model output. For our analysis we select parameter settings so as to focus on longer-term trends, and in an eort to reduce turnover, we preference a smooth output6 . Given these objectives, we develop a model and wish to perform an initial evaluation of its merits. Our proportion of interest is M M =

M j =1 N i=2

I [sgn(Sj,i1 ) = sgn(Dj,i )] M (N 1)

(1)

model of Xt = + Xt1 + which we calculated using Ordinary Least Squares (OLS) with a sample size of fteen days. We acknowledge this is a crude approximation but given the number of estimations made relative to the overall size of the sample, we feel it is sucient. 5 We use adjusted closing prices as they adjust for price impact of ex-dividend and splits. In addition, for all 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 settings that were based upon the research of Moskowitz et al and Baltas & Kosowksi.

where M = 23 are the number of assets, N = 2982 is the number of observations per asset, I [] is the Indicator function, sgn() is the the Sign function, Sj,i is our model signal and Dj,i = Pj,i Pj,i1 is the price dierential for observation i for the j th asset using adjusted closing prices. We estimate this proportion as M M = 0.5212, which using a standard normal distribution, provides sucient evidence to conclude that the proportion of interest is not equal to 0.57 . We note that this simple proportion does not account for implementation or execution costs but does illustrate that the model does have predictive power given our data set.

3.2

Portfolio Strategies

In regards to strategy we focus on three variations which we dene as Absolute Momentum (AM), Cross-Sectional Momentum (CM) and Cross-Sectional, Absolute Momentum (CAM). With Absolute Momentum we invest in all available assets with our momentum model dictating whether to own the asset or be at8 . In this formulation our modied signal becomes Buy if SM M,j,t >= 0 SAM,M M,j,t = (3) F lat otherwise where SM M,j,t is the raw signal from our model for asset j at time t. Since our model attempts to estimate the momentum of an asset, and given the literature that shows the poor performance of losing stocks relative to winners, we close out a position when we estimate it will be a loser. Within our Cross-Sectional Momentum strategy we subset the available set of assets by investing in those assets whose signal rank is less than a specied threshold. In this formulation our modied signal becomes SCM,M M,j,t = Buy if Rank(SM M,j,t ) <= U F lat otherwise (4)

with Rank() as the traditional Rank function and where U is a constant, user-specied rank threshold which determines the level of diversication within the portfolio at time t. In certain implementations of this type of strategy, the threshold is specied ex ante based upon factors such as model characteristics, desired portfolio return characteristics or investor mandate. For our implementation we devise a dynamic, data dependent rank threshold which we term Dynamic Threshold (Inverse Herndahl-Hirschman) [DT(IHH)], described in detail

This formulation is indierent to the magnitude of the price movement and therefore we tested an alternate formulation. Let our alternate proportion of interest be MM =

M j =1 N i=2 7

M j =1 N i=2

|Dj,i1 |

(2)

where M , N , I [], sgn(), Sj,i , Dj,i = Pj,i Pj,i1 are the same as before and | | is the Absolute function. For our data, the estimate of this alternate proportion, M M = 0.5265, also provides sucient evidence to conclude that the proportion of interest is not equal to 0.5. 8 The term at is a market colloquialism to denote having no position in an asset.

t = {1, ..., M }. Given this formulation, our in Appendix A, which in turn yields an output U Cross-Sectional Momentum strategys modied signal becomes SCM,M M,j,t = t Buy if Rank(SM M,j,t ) <= U F lat otherwise (5)

with the same denitions as in (4). The intent of this strategy is to subset the available assets as we believe those within our sub-sample will have superior ex post performance. Note, this is not mean-variance optimal as in that scenario we would assign very small, or even negative, weights to those assets our model estimates to be the losers. However, given the practical implementation issues of noisy estimates, and innitesimally small positions sizes, we elect to stratify our asset pool with the expectation that our model will be able to identify the winners. With the Cross-Sectional, Absolute Momentum strategy we take a long position in an asset if it has a positive signal whose rank is less than a specied threshold which yields a modied signal of SCAM,M M,j,t = t AND SM M,j,t >= 0 Buy if Rank(SM M,j,t ) <= U F lat otherwise (6)

with the same denition as in (4) and (5). The purpose of this double-sort strategy implementation is to not only identify the winners, but only purchase them when we expect them to have positive returns. Since our model does not provide estimates of returns, we can not operate in the meanvariance framework in a traditional sense when determing portfolio weights. Almgren & Chriss (2005) develop a methodology for creating optimal portfolios within the mean-variance framework from ordering, or rank, information. In addition, Black & Litterman (1992) oer a framework to take probabilistic views in conjunction with market-based estimates of returns to derive weights. However, DeMiguel et al (2009) analyze the performance of various portfolio weight schema versus the naive equally-weighted (EW) benchmark when allocating wealth to portfolios and nd that based upon numerous metrics that EW outperforms9 . Given this we focus on using an EW portfolio weight scheme which yields portfolio weights at time t for the j th asset of 1 (7) wj,t = Mt t , 23} depending on the strategy employed.10 . Note that when employing where Mt = {U either the AM or CAM strategy, we allocate the weight of a position to cash if the model dictates.

This is applicable in our case as an ETF is a portfolio of stocks. In addition, Jegadeesh & Titman (1993) use equal weighting within their portfolios and this allows us to make some comparisons with their research. 10 Barroso & Santa-Clara (2012) found a signicant reduction in portfolio risk estimates for portfolios formed via momentum which controlled for volatility. Given these results, dene risk parity as weighting schema that attempts to allocate capital to positions based upon the inverse of an appropriate measure of dispersion, or volatility, such that wj,t =

1 Vj M 1 j =1 Vj 9

(8)

In regards to portfolio turnover due to signal, we will specify a time frequency of monthly and quarterly given that the literature shows that holding periods of 1-3 months are optimal. In addition, we specify time frequencies to rebalance the portfolio so as to align the current positions with the optimal positions, which for our simulations we specify as monthly and quarterly as well. Given this set-up we will test six variations of the strategies: Absolute Momentum - Monthly & Quarterly Rebalance; Cross-Sectional Momentum - Monthly & Quarterly Rebalance; and Cross-Sectional, Absolute Momentum - Monthly & Quarterly Rebalance.

3.3

Competing Models

Our rst competing, or benchmark, model is a Buy & Hold (BH) strategy where we establish long positions in all twenty-three assets and rebalance on the above stated frequencies, which yields Buy & Hold - Monthly Rebalance and Buy & Hold - Quarterly Rebalance. This model should be seen as a naive model as it conveys no information about the expected relative performance of an asset. From a practical standpoint, it can also be seen as the performance of investing in an passive index fund that seeks to mimic the performance of an equallyweighted index11 . Our next competing model is a Momentum (Scaled) model (Mo) with a specied formation period of T = 252 trading days as the research by Jegadeesh & Titman and others have shown that this is the optimal formation period12 . Given this set-up our Momentum model signal for the jth asset at time t is SM o,j,t = log (Pj,t ) log (Pj,tT ) j,t (9)

where Pj,t is the adjusted closing price, and j,t is the standard deviation of the log returns for the period T 13 . We scale the momentum as recommended by Moskowitz et al so as to compare asset signals14 . Given this raw signal, our modied signals become SAM,M o,j,t = Buy if SM o,j,t >= 0 F lat otherwise (10)

where Vj is a measure of dispersion. With this formulation we tested three variations of risk parity (Standard Deviation, Semi-Deviation, and Median Absolute Deviation) and all three variations under-performed the equally-weighted portfolio for all strategies, rebalancing rules and models. 11 We will use an equally-weighted index, using adjusted closing prices, as our market portfolio when performing return attribution analysis. 12 We use 252 days as it is the average number of trading days in a year. Also note that we do not delay the formation of the portfolio as suggested by Novy-Marx and Jegadeesh & Titman for the sake of simplicity. We note that this may not be optimal and therefore recognize the results may not be an optimal competing model. 13 Similar to our model, we estimate M o = 0.5320 and M o = 0.5336 both of which provide sucient evidence to conclude that the proportion of interest is not equal to 0.5. 14 Note that due to the autocorrelation present in the log returns, the sample standard deviation estimator will be biased beyond the traditional bias. We do not attempt to mitigate this bias and note the shortcoming. Also note that Moskowitz et al use an exponentially-weighted volatility measure when scaling the momentum statistic but we use the sample estimator due to simplicity.

for our Absolute Momentum strategy variation, SCM,M o,j,t = t Buy if Rank(SM o,j,t ) <= U F lat otherwise (11)

for our Cross-Sectional Momentum strategy variation, and SCAM,M o,j,t = t AND SM o,j,t >= 0 Buy if Rank(SM o,j,t ) <= U F lat otherwise (12)

The purpose of simulating results, or back-testing, is to gauge the eectiveness of a strategy, given specied assumptions, and to generate statistics that can be analyzed prior to strategy implementation. However, it should be noted that no matter how rigorous the simulation that it will always fail in what we desire it to achieve: namely, to specify the future return characteristics of a strategy. Nonetheless, supported by solid economic and nancial research, simulated results can be a useful tool for evaluation. With this in mind we design, using R, a back-testing algorithm16 . This algorithm attempts to simulate the hypothetical portfolio characteristics by applying our strategy on historical price data. The steps of our algorithm are listed herein.

4.1

The rst step is to get the model signal, based upon the strategy to be tested, for each of the specied ETFs from the prior day. This is done so as to avoid peeking forward since our model is trained using adjusted closing prices and utilizing todays signal value would be tantamount to using future information when assessing whether to trade or not.

4.2

Step Two: Assess Fees; Accrue Interest & Dividends; Adjust for Splits

The next step is to assess management fees if todays historical date is the beginning of a month. For our simulation we assess a 2% management fee which is applied on the prior days simulated account equity17 . Then we accrue interest earned on our cash balance from

Note we tested the results of the competing, benchmark momentum model without volatility scaling and the results were not statistically dierent. This may be due to our choice of a volatility estimate or the assets themselves. However, so as to align our results with the literature cited, we continue to employ volatility scaling. 16 R is a scripted programming language that is actively supported, free and with robust documentation (http://www.r-project.org). For our development we utilize R, version 2.15.3 and R Studio (http://www.rstudio.com) as an Integrated Design Environment (IDE). 1 2% 17 The strict convention is to asses 12 th of the fee each month, so in our case we assess ( 12 ) per month.

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the prior day using the specied risk free rate minus a 0.50% brokerage fee18 . Lastly, we accrue dividends earned if that day is an ex-dividend date and also adjust our portfolio holdings for stock splits. The purpose of including fees, interest and dividends is to provide more realistic simulated returns since these are impacted by our model/strategy combination. In addition assessing management fees is crucial given its impact on the cumulative results and the purchasing power of the hypothetical account.

4.3

The starting capital for our simulation is $25,000 and our target portfolio allocation is 98%19 . With these two parameter inputs we calculate the optimal position quantities, using yesterdays closing prices, the portfolio weight scheme and our current signals.

4.4

Next we determine if the current date is a trade date based upon the proposed trading frequency and determine if trades are warranted due to the signal or if we need to optimize a position. If so, we create opening or closing trades within our internal blotter and then we peek ahead to determine if we could have theoretically traded that day by seeing if, rst, there is any trading volume for the day; and secondly, whether our trade quantity doesnt exceed 100% of that days volume. If either of these are false, we conduct the trades but adjust the slippage amount that we discuss in the next sub-section20 .

4.5

If we need to conduct trades we do so using the opening price adjusted by the commission rate of $0.05 per share and the trade slippage.21 In regards to trade slippage it is a statistic that quanties the dierential in price from when a signal is received and the actual

0.005) ], where we use the 360 day convention. In addition, the brokerSpecically the rate is M ax[0, (F F 360 age fee used is one that is employed currently by Interactive Brokers (http://www.interactivebrokers.com) and is seen as a conservative estimate of what a hypothetical brokerage would charge. 19 We set our capital amount at this level as our target investor is a retail investor, although the strategy is equally applicable for an institution. It should be noted that since one of our simulation checks is to determine whether a trade could be conducted on a given day, that the lower initial capital amount aects the ability, and timing, of our trades. We recognize this shortcoming in our simulation but also note that it does not adversely impact, nor favor, any specic model. In addition, we specify a 98% target allocation so as to maintain a cash balance for the purposes of account fees and to account for the fact that there may be a dierential between todays open price and yesterdays close when determining position quantities. In the latter case, we could theoretically assume the investor waited till the open and use the opening price, but as we are attempting to capture the opening liquidity, we do not chose this option. 20 This approach can be viewed as synonomous with working a trade over a longer time period than that which we specify for a normal trade. In these cases, in lieu of scaling the volatility detailed in (13) we use the full amount as a trade impact estimate. 21 The commission rate is higher than the prevailing industry rate, and what was charged at the beginning of the simulation, but we since we do not adjust for the bid-ask spread, and we are uncertain if the customer was charged a at rate, we continue to use this rate. 18

trade price. Normally, it is used as a measurement of trade execution and price impact in real-time scenarios but for our simulation it is used as a price adjustment that attempts to quantify the potential trade impact, bid/ask spread and price uncertainty had we actually traded that day. In most simulations this is a xed amount but for our simulation we use a localized measure based upon high and low prices. Berkowitz et al (1988) found that the percentage range for a stock, (High Low)/Low 100, had a statistically signicant impact on the market impact costs, while controlling for commissions and trade volume, for NYSE stocks for the rst quarter of 1985. Therefore we develop a statistic that uses the range to quantify the expected slippage, or implicit transaction costs, for a stock. Parkinson (1980) developed a range-based volatility estimator t =

n i=1

i log ( H ) Li

4 log (2) n

(13)

at time t and where Hi is the High Price, Li is the Low Price and n is the sample size22 . We T 23 then adjust our opening price by a scaled amount of 390 . After incorporating commissions and slippage, our nal trade price is t = O Ot + Ot

t 30 390 t 30 390

+ 0.05

if Buy Order

(14)

4.6

Step Six: Calculate Prot & Loss; Adjust Account Equity, Positions and Cost Basis

Our last step is to calculate the prot & loss of the simulated portfolio using that days closing price relative to the previous days closing price. We then adjust our account equity which is a function of our starting capital and our accrued prots and losses. This is important as our margin levels have an impact on our trading activities. Lastly, we adjust our cost basis to reect all incremental increases in our position(s) so as to have accurate per trade return statistics.

The earliest starting date where all ETFs trade is June 23, 2000, and with model training and additional days needed for back-testing implementation, our simulation start date is

For our simulation we use n = 22 as it represents the amount of trading days in a typical month. We use (390) as this converts our volatility estimate into a minute frequency and then use use T = 30 as a conservative estimate of the amount of time, in minutes, that we expect that it would take to complete a trade. 24 There exist more advanced models for slippage that include volume in their functional argument. However, we continue to use our estimate due to its simplicity and due to the fact that slippage is less of a factor in our simulations due to low turnover.

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October 3, 2001 and our nal date is May 1, 2013. In Tables 5, 6, 7, 6, 9 and 10 we see the results of our six strategy variations using diering statistics25 . In what follows, we will briey discuss some of the statistics, their background and signicance. The annualized returns and volatility are computed in the standard manner and provide insight into the risk-reward proles of the strategies26 . Specically, with the annualized returns we can see that the BH strategy outperforms all models for all strategy variations save the CAM-Quarterly where our model outperforms. Brinson et al (1986,1991) provide an analytical framework so as to decompose the returns of a strategy versus a benchmark. Within this framework we can say that our security selection is inferior to the benchmark except in the case of the CAM-Quarterly strategy but we also note that when performing a Kruskal-Wallis test we fail to reject the null hypothesis that the returns are from the same distribution. Given this fact, there isnt any statistical evidence that the returns dier for any of the model/strategy combinations. With the annualized volatility we see a marked dierence when employing the AM & CAM strategies which is to be expected given their ability to invest in the relatively low volatility and autocorrelated cash asset. The Sharpe Ratio, which was proposed by Sharpe (1966), is a measure to quantify the reward-to-risk prole of a portfolio within the meanvariance framework that uses the excess returns from a portfolio27 . For all of the strategy variations, we can see that our model outperforms the Mo(S) model but it only outperforms the BH model when again employing the AM & CAM strategies. However, it should be noted that the Sharpe Ratio is sensitive to issues of non-normality and violations of iid which are revealed via the Jarque-Bera and Ljung-Box statistics for the returns28 . Given some of the issues with the Sharpe ratio, Keating & Shadwick (2002) proposed an alternate statistic to measure the risk-reward trade-o they termed Omega that uses the cumulative distribution function (CDF) which incorporates the entire distribution of a data series29 . We use the excess returns as our data series and a threshold, = 0 since an (0) = 1 would indicate an inability to generate returns in excess of the risk-free rate30 . We note that all of our results demonstrate an ability to generate returns that are superior to investing in the risk-free rate but also note that there isnt much variation in the results. This is a function of the we selected but as we wanted to contrast this statistic with the Sharpe Ratio, and that statistic estimates performance relative to the risk-free rate, we made this choice of . Another risk metric is the Maximum Drawdown (MaxDD) which attempts to quantify the greatest potential run of losses for a portfolio. As with the volatility statistic,

25 The Buy & Hold is strategy, which only has two variations, is listed along with the other two models for it comparable rebalancing frequency. 26 Specically, the annualized return is the average daily return multiplied by 252 and the annualized volatility is the daily standard deviation multiplied by the square root of 252. 27 We employ the variation which uses the excess returns when calculating the standard deviation. 28 Ledoit & Wolf (2008) discuss methods for mitigating these issues in the context of performing hypothesis tests between Sharpe ratios but for the sake of brevity we do not attempt to deal with this issue and report the Sharpe ratios as computed 29 In their cited paper the authors called the statistic Gamma, but in later works they changed its name to Omega. 30 Note, that we employ a non-parametric, kernel density estimator to estimate our distribution. Also, given the non-linear characteristic of the CDF, the choice of can have a signicant impact on the resulting Omega statistic.

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we can clearly see that allowing the portfolio to increase its exposure to cash greatly reduces the MaxDD. Next, we evaluate Jensens which was proposed by Jensen (1968) as an extension of the Capital Asset Pricing Model (CAPM) [Sharpe (1964)], for the analysis of mutual fund performance using an appropriate market portfolio and risk-free rate. To analyze the performance our model & strategy combination we construct an equal-weighted index of returns from the log returns of the assets and use the 3-Month T-Bill rate as our risk-free rate so as to create market portfolio excess returns. Given this formulation, we conduct Ordinary Least Squares (OLS) to estimate the parameters but also conduct diagnostic tests on our results. Breusch & Pagan (1979) developed a Lagrange Multiplier test for hetereoskedascity and we can see that for some of the results that it is present31 . In addition to this, Breusch (1979) and Godfrey (1978) independently developed a Lagrange multiplier test to determine the presence of autocorrelated error terms and we can see that for all of the models, save BH, that there exists statistically signicant autocorrelation. Lastly we perform Jarque & Bera tests on our OLS residuals to determine if normality is violated and see that in all cases that our residuals violate our normality assumption32 . We do not correct for this last violation, but given the existence of heteroscedasticity and autocorrelation, when determining the statistical signicance of our OLS parameter estimates we use adjusted standard errors using Heteroscedasticity Consistent (HC) and Heteroscedasticity and Autocorrelation Consistent (HAC) estimators as discussed in Zeileis (2004, 2006)33 . With these corrections we can see that none of our Jensens are statistically signicant except for the momentum model using the CM-Monthly strategy. However, all of our beta estimates are statistically signicant and we note that when employing the AM & CM strategies, we see the expected reduction in covariance with the market portfolio due to the varying exposure to this asset class. Lastly, we list statistics related to the trading results of the individual assets and note a few details in calculation. For slippage, we report all trades inclusive of rebalancing trades along with trades due to signal change. Berkowitz et al found the average market impact costs, which used the percentage price dierential from the volume-weighted average price (VWAP), of 0.23% for NYSE stocks for the rst quarter of 1985. Jones (2002) found for the period of 1900-2001 that the average annual transaction costs for NYSE stocks, incorporating bid-ask spreads, was 0.38% with a standard deviation of 0.32%. These estimate contrast with our estimates which range from 0.24%-0.29% depending on strategy or model. Given this,

We do not use the test developed by White (1980) as it is a more general test that also tests for model mis-specication and we are only interested in the presence of heteroscedasticity as CAPM dictates a linear relationship. 32 Gauss-Markov does not assume normality for the residuals, however, the Maximum Likelihood Estimaors (MLE) for OLS are no longer the Uniform Minimum Variance Unbiased Estimators (UMVUE) if normality is violated. 33 We use a critical level of 5% from the Breusch-Pagan and Breusch-Godfrey to determine whether to reject the null hypothesis in favor of heteroscedasticity and autocorrelation respectively. In the presence of heteroscedasticity, with no autocorrelation, we use the vcovHC() function within R as a HC estimator using the default settings. In the case of autocorrelation, regardless of the presence of heteroscedasticity, we use the vcovHAC() function within R as a HAC estimator using the default settings. Andrews (1991) showed that in cases of autocorrelation with homoscedasticity that the Quadratic-Spectral Kernel Estimator, the default within vcovHAC() is nearly as optimal as the most ecient estimator in that scenario, titled PARA. Therefore we feel there is minimal loss of eciency for using it in both cases.

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we feel that our slippage estimates are adequate given the research and also note that due to our low turnover, that slippage is less of factor relative to commission costs. In addition, the Number of Trades statistic that is reported does not include rebalancing trades but only trades that are due to signal. We do this as rebalancing trades are a function of the assets themselves and not entirely a function of the model34 . We can see that all of the strategy variations have low turnover rates which is a function of the time frame used to estimate their signals. Lastly, we report the mean and standard deviation of trade returns but note that these statistics do contain all trades and not those solely based upon signal. We do this as our rebalancing rule may facilitate the capture of gains or losses that arent entirely reected in a trade as dictated by signal35 .

Our results show that our model is superior to the momentum model used in the literature but not in statistically signicant manner. In addition, rebalancing on a quarterly basis provides superior results which was also detailed by Jegadeesh & Titman (1993). However, in almost all cases, both models underperform a simple Buy & Hold strategy. This realization could be a function of the assets selected and the time period analyzed. In addition, as our initial Kruskal & Wallis test illustrates, the assets we selected are fairly homogenous which in turn may negate the ability of any model to dierentiate the winners from the losers. This last fact motivates us to perform further research using our model on a wider range of assets and for dierent time periods. However, our dynamic threshold algorithm appears to show solid performance especially given that it allows for a mechanical, ex ante estimation of the proper number of assets. Further research is needed to determine if the time-frame selected, or the choice of assets, have an impact on its performance.

References

[1] Almgren, R. and Chriss, N. (2005) Portfolios from Sorts [2] Andrews, D. (1991) Heteroskedasticity and Autocorrelation Consistent Covariance Matrix Estimation, Econometrica 59(3), 817-858 [3] Ang, A. and Chen, J. (2002) Asymmetric correlations of equity portfolios, Journal of Financial Economics 63(3), 443-494 [4] Antonacci, G. (2013) Risk Premia Harvesting Through Dual Momentum [5] Baltas, A-N. and Kosowski, R. (2012) Momentum Strategies in Futures Markets and Trendfollowing Funds

Strictly speaking this is not the case for the CM & CAM as their selection of assets may lead to owning the more volatile assets relative to the larger population. We recognize this, but in lieu of adding more granular statistics, we employ the statistic listed. 35 We could create a weighted average trade return but forgo this exercise as trade returns are not the statistics of interest but rather those associated with the portfolio.

34

12

[6] Barroso, P. and Santa-Clara, P. (2012) Managing the Risk of Momentum [7] Berkowitz, S., Kogue, D. and Noser, E. (1988) The Total Costs of Transactions on the NYSE, The Journal of Finance 43(1), 97-112 [8] Black, F. and Litterman, R. (1992) Global Portfolio Optimization, Financial Analysts Journal 48(5), 28-43 [9] Bollerslev, T. (1986) Generalized Autoregressive Conditional Heteroskedasticity, Journal of Economics 31, 307-327 [10] Breusch, T. and Pagan, A. (1979) A Simple Test for Heteroscedasticity and Random Coecient Variation, Econometrica 47, 12871294 [11] Breusch, T. (1979) Testing for Autocorrelation in Dynamic Linear Models, Australian Economic Papers 17, 334355 [12] Brinson, G., Hood, L. and Beebower, G. (1986) Determinants of Portfolio Performance, Financial Analysts Journal 42(4), 39-44 [13] Brinson, G., Hood, L. and Beebower, G. (1991) Determinants of Portfolio Performance II: An Update, Financial Analysts Journal 47(3), 40-48 [14] Cahart, M. (1997) On Persistence in Mutual Fund Performance, The Journal of Finance 52(1), 57-82 [15] Chan, L., Jegadeesh, N., and Lakonishok, J. (1996) Momentum Strategies, The Journal of Finance 51(5), 1681-1713 [16] Chow, K. and Denning, K. (1993) A Simple Multiple Variance Ratio Test, Journal of Econometrics 58, 385-401 [17] Das, S. and Uppal, R. (2004) Systemic risk and international portfolio choice, The Journal of Finance 59(6), 2809-2834 [18] de Bondt, W. and Thaler, R. (1985) Does the Stock Market Overreact?, The Journal of Finance 40(3), 793-805 [19] DeMiguel, V., Garlappi, L., and Uppal, R. (2009) Optimal Versus Naive Diversication: How Inecient is the 1/N Portfolio Strategy?, The Review of Financial Studies 22(5), 1915-1953 [20] Fama, E. and French, K. Size, Value, and Momentum in International Stock Returns, Journal of Financial Economics 105(3), 457-472 [21] Fisher, L. and Lowrie, J. (1970) Some Studies of Variability of Returns on Investments in Common Stocks, The Journal of Business 43(2), 99-134 [22] Godfrey, L.G. (1978) Testing Against General Autoregressive and Moving Average Error Models when the Regressors Include Lagged Dependent Variables, Econometrica 46, 12931302 [23] Hirschman, A. (1964) The Paternity of an Index, The American Economic Review 54(5), 761

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[24] Jarque, C. and Bera, A. (1987) A Test for Normality of Observations and Regression Residuals, International Statistical Review 55(2), 163-172 [25] Jegadeesh, N. and Titman, S. (1993) Returns to Buying Winners and Selling Losers: Implications for Stock Market Eciency, The Journal of Finance 48(1), 65-91 [26] Jegadeesh, N. and Titman, S. (2001) Protability of Momentum Strategies: An Evaluation of Alternative Explanations, The Journal of Finance 56(1), 699-720 [27] Jensen, M. (1968) The Performance Of Mutual Funds In The Period 1945-1964, The Journal of Finance 23(2), 389-416 [28] Jones, C. (2002) A Century of Stock Market Liquidity and Trading Costs [29] Kahneman, D. and Tversky, A. Intuitive Prediction: Biases and Corrective Procedures In Kahneman, D., Slovic, P., and Tversky, A. (eds) Judgment Under Uncertainty: Heuristics and Biases. London: Cambridge University Press (1982) [30] Keating, C. and Shadwick, W. (2002) A universal performance measure, Journal of Performance Measurement 6(3), 5984 [31] Kritzman, M., Li, Y., Page, S. and Rigobon, R. (2010) Principal Components as a Measure of Systemic Risk [32] Kruskal, W. and Wallis, W. (1952) Use of Ranks in One-Criterion Variance Analysis, Journal of the American Statistical Association 47(260), 583-621 [33] Ledoit, O. and Wolf, M. (2003) Improved estimation of the covariance matrix of stock returns with an application to portfolio selection, Journal of Empirical Finance 10(5), 603-621 [34] Ledoit, O. and Wolf, M. (2008) Robust performance hypothesis testing with the Sharpe ratio, Journal of Empirical Finance 15(5), 850-859 [35] Ljung, G. and Box, G. (1978) On a Measure of Lack of Fit in Time Series Models, Biometrika 65, 297303 [36] Mandelbrot, B. (1963) The Variation of Certain Speculative Prices, The Journal of Business 36(4), 394-419 [37] Mann, H. and Whitney, D. (1947) On a Test of Whether one of Two Random Variables is Stochastically Larger than the Other, Annals of Mathematical Statistics 18(1), 50-60 [38] Markowitz, H. Portfolio Selection: Ecient Diversication of Investments. New York: John Wiley & Sons (1959) [39] Moskowitz, T., Ooi, Y., and Pedersen, L. (2012) Time series momentum, Journal of Financial Economics 104(2), 228-250 [40] Novy-Marx, R. (2012) Is momentum really momentum?, Journal of Financial Economics 103(3), 429-453

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[41] Opgen-Rhein, R. and Strimmer, K. (2007) Accurate Ranking of Dierentially Expressed Genes by a Distribution-Free Shrinkage Approach, Statistical Applications in Genetics and Molecular Biology 6(1) [42] Parkinson, M. (1980) The Extreme Value Method for Estimating the Variance of the Rate of Return, The Journal of Business 53(1), 61-65 [43] Rouwenhorst, K. (1998) International Momentum Strategies, The Journal of Finance 53(1), 267-284 [44] Sharpe, W. (1964) Capital Asset Prices: A Theory of Market Equilibrium under Conditions of Risk, Journal of Finance 19(3), 425-442 [45] Sharpe, W. (1966) Mutual Fund Performance, The Journal of Business 39(1), 119-138 [46] Statman, M. (1987) How Many Stocks Make a Diversied Portfolio?, Journal of Financial and Quantitative Analysis 22(3), 353-363 [47] Statman, M. (2004) The Diversication Puzzle, Financial Analysts Journal 60(4), 44-53 [48] Tversky, A., and Kahneman, D. (1974) Judgment under Uncertainty: Heuristics and Biases, Science 185(4187), 1124-1131 [49] Sch afer, J., and Strimmer, K. (2005) A Shrinkage Approach to Large-scale Covariance Estimation and Implications for Functional Genomics, Statistical Applications in Genetics and Molecular Biology 4(1) [50] White, H. (1980) A Heteroskedasticity-Consistent Covariance Matrix Estimator and a Direct Test for Heteroskedasticity, Econometrica 48(4), 817-838 [51] Wilcoxon, F. (1945) Individual Comparisons by Ranking Methods, Biometrics Bulletin 1(6), 80-83 [52] Zeileis, A. (2004) Econometric Computing with HC and HAC Covariance Matrix Estimators, Journal of Statistical Software 11(10), 117 [53] Zeileis, A. (2006) Object-oriented Computation of Sandwich Estimators, Journal of Statistical Software 16(9), 116

15

We desire to develop a metric that determines our rank threshold dynamically and in a data dependent manner. Markowitz (1959) noted that as the correlation of assets increases the benets of diversication decreases. In addition, Statman (1987,2004) addresses the issue of how many assets make a diversied portfolio, and extending upon Markowitzs work, denes the problem as the marginal benet from reduction in the portfolio standard deviation versus the marginal cost of transaction costs. Therefore given these claims we seek a metric that measures the amount of diversication present in our choice of assets. Kritzman et al (2010) mentioned the usage of a Herndahl Index in conjunction with the eigenvalues of a Principal Component Analysis (PCA) of the return data so as to measure the ability of a market to absorb systemic shocks36 . In addition Fisher & Lowrie (1970) used a Gini coecient of concentration along with its mean dierence to measure the eect of diversication of a portfolio by quantifying the amount of dispersion amongst assets. Within this forumulation, let PCA be the procedure that solves V = V (15)

where is the covariance or correlation matrix of X , V is the matrix of eigenvectors corresponding to the vector of eigenvalues, , and which we estimate using the princomp() function, with an inputted covariance matrix, in R. However, due to the non-normality of our data, we use a robust covariance matrix estimate as outputted by the cov.shrink() function in R as described in Sch afer & Strimmer (2005) and Opgen-Rhein & Strimmer (2007). They proposed using a Ledoit & Wolf (2003) shrinkage estimator to estimate the components of covariance matrix such that i,j = s2 2 1 median + (1 1 )si,j )) s2 s2 i,j min(1, max(0, 1 2 i,i j,j if i = j if i = j (16)

2 where i,j is the sample correlation, s2 i,j is the sample variance, smedian is the median of the sample variances, M 2 k=1 V ar (sk ) = min(1, ) (17) 1 M 2 2 k=1 sk smedian

is the shrinkage estimate for the variance estimates given the number of covariates, M , = 2

i=j

(18)

36

ar(s2 k)

n = (n 1)3

(wi,k w k )2

i=1

(19)

It should be noted that Hirschman (1964) claimed the paternity of the index that normally bears Dr. Herndahls name.

16

is an estimate of the standard error of s2 k = k given the sample size n, x n 1 2 (xi,k x k ) , w k = n k=1 wi,k and V ar() = n (n 1)3

n 2 (wk,i,j w i,j ) i=1 x x

1 n

n k=1

xi,k , wi,k =

(20)

n i 1 is an estimate of the standard error of given zk,i = k,i , z i = n k=1 zk,i , wk,i,j = si n 1 (zk,i z i )(zk,j z j ), and w i,j = n k=1 wk,i,j . Given this estimate of the covariance matrix, and the estimates of the eigenvalues from the PCA, let the Dynamic Threshold (Inverse Herndahl-Hirschman) [DT(IHH)] at time t Pj,t of a data matrix, X (t), comprised of the log returns, rj,t = log ( Pj,t ), be dened as 1

1 DT (IHH )t =

M i=1

1 M

(21)

where M is the number of assets and DT (IHH ) [0, 1]. We then dene our dynamic threshold value at time t as t = max( DT (IHH )t M , 1) U (22)

t = {1, ..., M }. For our simulation we arbitrarwhere is the rounding function and U ily select a historic time-frame of 66 days when calculating our DT (IHH )t as we wish to have enough data to estimate our covariance matrix but a shorter time-frame due to the heteroscedasticity present in the data. It should be noted that we did test the performance of the models and strategy combinations using the sample covariance matrix and in all cases they had statistically inferior results versus using the robust covariance method. In addition, we did contemplate employing a Exponentially Weighted Moving Average (EWMA) or Dynamic Conditional Correlation (DCC) approach to mitigate the eects of the heteroscedasticity but we chose to save that for further research. Lastly, there didnt exist a signicant dierence between calculating DT(IHH) using the covariance matrix or the correlation matrix which may be due to the homogeneity of the asset returns. In an eort to test the eciency of our dynamic threshold we perform backtest simulations for xed thresholds U = {1, ..., 23} for the CM & CAM strategies. In lieu of reporting all of the simulation statistics, we focus on the Omega(0) statistic using excess returns with the results listed in Figures 1, 2, 3 and 437 . In these results we can see that, although, our algorithm does not yield the optimal threshold it does capture the majority of the risk-reward available for each strategy variation. In addition to this evaluation, we explore an alternate formulation of our dynamic threshold that uses a Herndahl-Hirschman index and not its inverse. Using the same denitions as those in (21) and (22), let our alternate threshold be t = max( DT (HH )t M , 1) U

37

(23)

= 10.43 for the simulation period For reference our DT(IHH) yields a mean value of U

17

M i=1 i,t M i=1 i,t 1 M

1 M

(24)

which is again normalized to yield an output DT (HH ) [0, 1]. Given this alternate method, we perform simulations using our model for the four strategy variations that employ a dynamic threshold and list those results in Table 11. We can see that for our CM strategy that there is little dierence but there is a dierence for both CAM strategy variations. In addition to these results we perform Mann-Whitney-Wilcoxon tests on all four simulation pairings with an alternate hypothesis that the returns from the DT(IHH)-based results are greater than those from the DT(HH). In all four tests we nd insucient evidence to conclude that the returns using the DT(IHH) are greater than those employing the DT(HH) variation. Lastly, we plot the threshold estimates using DT(IHH) and DT(HH) in Figures 6 and 7 respectively along the benchmark index in Figure 5 for comparison. Given that the DT(HH) estimates the amount of dispersion within a covariance matrix, we can see some of the stylized facts documented in Ang & Chen (2002) and Das & Uppal (2004). Namely, that changes in the correlation structure have an asymmetric nature which is realized as a greater increase in correlation during market declines. Therefore we see a decrease in our threshold using the DT(IHH) during market declines and increase in number of assets, due to a decrease in correlation, during the market rally of 2006-2007.

18

Ticker EWA EWC EWG EWH EWI EWJ EWS EWT EWW EWY IWM MDY QQQ SPY XLB XLE XLF XLI XLK XLP XLU XLV XLY

Description iShares MSCI Australia Index iShares MSCI Canada Index iShares MSCI Germany Index iShares MSCI Hong Kong Index iShares MSCI Italy Capped Index iShares MSCI Japan Index iShares MSCI Singapore Index iShares MSCI Taiwan Index iShares MSCI Mexico Capped Investable Market iShares MSCI South Korea Capped Index iShares Russell 2000 Index SPDR S&P MidCap 400 PowerShares QQQ SPDR S&P 500 Materials Select Sector SPDR Energy Select Sector SPDR Financial Select Sector SPDR Industrial Select Sector SPDR Technology Select Sector SPDR Consumer Staples Select Sector SPDR Utilities Select Sector SPDR Health Care Select Sector SPDR Consumer Discretionary Select Sector SPDR

Table 1: Ticker symbols and their descriptions for the ETFs used in the analysis. Information obtained from Yahoo! Finance

Table 2: Descriptive statistics Eective Fed Funds (EFF) rate and 3-Month Treasury Bill: Secondary Market (3MTB) rate for the period of October 3, 2001 through May 1, 2013. Note these statistics are based upon the daily rate using the 360 day convention to convert the quoted datum.

19

Number of Observations Mean Price Minimum Price Maximum Price Standard Deviation JBa Qb

Number of Observations Mean Price Minimum Price Maximum Price Standard Deviation JB Q

20

XLF 3,232 20.28 5.77 33.35 5.96 91.62*** 3,223.99*** XLI 3,232 27.3 14.01 42 6.16 111.9*** 3,217.89*** XLK 3,232 21.68 10.27 50.93 6.17 4497.31*** 3,201.97*** XLP 3,232 22.76 14.26 41.43 5.41 757.24*** 3,218.43***

Number of Observations Mean Price Minimum Price Maximum Price Standard Deviation JB Q

Table 3: Descriptive statistics of the adjusted close prices for the ETFs within the analysis for the period of 6/23/00 through 5/1/13. *** signicant at 1% level, ** signicant at 5% level and * signicant at 10% level.

Number of Observations Mean Return Minimum Return Maximum Return Standard Deviation JBa Qb 1 c 1 M V1 d M V2

EWA 3,231 0.05% -13.18% 18.79% 1.87% 11,359.75*** 41.22*** 0.09*** 0.89*** 6.43*** 3.38***

EWC 3,231 0.02% -11.65% 11.68% 1.60% 3,941.04*** 3.77* 0.07*** 0.92*** 1.94*** 1.15

EWG 3,231 0.01% -12.01% 18.05% 1.86% 6,354.91*** 8.77*** 0.08*** 0.90*** 2.97*** 1.97

EWH 3,231 0.03% -13.08% 15.66% 1.83% 6,592.13*** 88.98*** 0.07*** 0.92*** 9.44*** 5.26***

EWI 3,231 0.00% -11.17% 14.25% 1.91% 3,818.66*** 17.78*** 0.07*** 0.92*** 4.22*** 2.80**

EWJ 3,231 0.00% -11.06% 14.65% 1.54% 6,081.59*** 41.9*** 0.09*** 0.89*** 6.47*** 3.90***

EWS 3,231 0.03% -11.90% 16.52% 1.86% 5,446.96*** 77.06*** 0.10*** 0.89*** 8.78*** 5.42***

EWT 3,231 0.00% -12.38% 13.26% 2.15% 2,031.58*** 34.71*** 0.07*** 0.92*** 5.90*** 4.24***

21

XLF 3,231 0.00% -18.21% 15.19% 2.14% 20,270.92*** 38.72*** 0.09*** 0.91*** 6.23*** 2.73** XLI 3,231 0.02% -9.90% 10.18% 1.46% 3,568.17*** 3.1* 0.09*** 0.91*** 1.96 1.32 XLK 3,231 -0.01% -9.06% 14.92% 1.76% 4,993.46*** 5.28** 0.07*** 0.92*** 3.51*** 2.20* XLP 3,231 0.02% -6.24% 6.65% 0.94% 2,566.15*** 28.78*** 0.08*** 0.91*** 5.38*** 3.57***

Number of Observations Mean Return Minimum Return Maximum Return Standard Deviation JB Q 1 1 M V1 M V2 XLU 3,231 0.02% -8.91% 11.43% 1.26% 12,536.5*** 16.88*** 0.12*** 0.87*** 4.11*** 1.98 XLV 3,231 0.02% -10.30% 11.38% 1.17% 10,912.25*** 0.94 0.10*** 0.89*** 2.72** 1.33

EWW 3,231 0.06% -13.24% 19.45% 1.92% 7,647.6*** 0.61 0.08*** 0.91*** 2.26* 1.34

EWY 3,231 0.03% -18.03% 20.24% 2.43% 8,969.91*** 14.46*** 0.07*** 0.93*** 3.96*** 2.48**

IWM 3,231 0.02% -11.93% 8.28% 1.64% 2,215.51*** 18.05*** 0.08*** 0.90*** 4.27*** 2.56**

MDY 3,231 0.03% -12.39% 11.33% 1.50% 7,665.15*** 5.79** 0.09*** 0.90*** 3.69*** 1.83

QQQ 3,231 -0.01% -9.36% 15.55% 1.87% 4,099.01*** 2.96* 0.07*** 0.93*** 3.65*** 2.24*

SPY 3,231 0.01% -10.37% 13.55% 1.33% 12,962.42*** 16.46*** 0.09*** 0.90*** 4.75*** 2.38*

XLB 3,231 0.03% -13.26% 13.15% 1.68% 3,689.51*** 2.3 0.08*** 0.91*** 2.48** 1.53 XLY 3,231 0.03% -12.37% 9.38% 1.53% 3,619.71*** 2.27 0.08*** 0.92*** 2.57** 1.57

XLE 3,231 0.03% -15.61% 15.26% 1.87% 11,181.49*** 10.87*** 0.07*** 0.92*** 4.66*** 2.33*

Number of Observations Mean Return Minimum Return Maximum Return Standard Deviation JB Q 1 1 M V1 M V2

Table 4: Descriptive statistics of the log returns of adjusted close prices for the ETFs within the analysis for the period of 6/24/00 through 5/1/13. *** signicant at 1% level, ** signicant at 5% level and * signicant at 10% level.

Jarque-Bera statistic. Ljung-Box statistic. c This, and below, are GARCH statistics. d This, and below, are Chow-Denning statistics.

Momentum Model Terminal Wealth $48,612.21 Total Dividends $4,812.95 Total Interest $1,019.14 Total Fees Paid ($8,520.04) Annualized Return 6.47% Annualized Volatility 12.02% Sharpe Ratio 0.45 Omega 1.15 MaxDD -17.92% Jarque-Bera 2737.24*** Ljung-Box 16.82*** ACF(1) -0.08 Alpha (Annualized) 2.72% Beta 0.37*** Breusch-Pagan 0.65 Breusch-Godfrey 17.92*** Jarque-Bera (Residuals) 5375.36*** Trading Prot & Loss $26,300.16 Total Commissions Paid ($2,105.8) Mean Slippage -0.25% StDev Slippage 0.15% Number of Trades 294 Average Holding Period 227.57 Mean Trade Return 19.16% StDev Trade Return 24.73%

Buy & Hold $52,892.72 $7,530.09 $146.79 ($8,884.08) 8.42% 21.31% 0.34 1.16 -58.03% 10035.85*** 20.05*** -0.08 0.46% 0.96*** 2.95* 0.26 129174755.55*** $29,099.91 ($2,369.1) -0.29% 0.22% 23 4228.00 35.65% 42.15%

Momentum (Scaled) $45,714.72 $4,876.19 $702.23 ($8,278.81) 5.95% 12.13% 0.40 1.14 -21.53% 4009.89*** 13.09*** -0.07 2.17% 0.37*** 1.68 13.73*** 5031.28*** $23,415.11 ($1,252.45) -0.24% 0.14% 133 495.89 30.24% 35.32%

Table 5: Performance statistics for the Absolute Momentum (AM) strategy with monthly rebalancing and $25,000 starting capital for the period of October 3, 2001 through May 1, 2013. *** signicant at 1% level, ** signicant at 5% level and * signicant at 10% level.

22

Momentum Model Terminal Wealth $46,391.61 Total Dividends $5,032.48 Total Interest $914.71 Total Fees Paid ($8,430.38) Annualized Return 6.07% Annualized Volatility 12.05% Sharpe Ratio 0.41 Omega 1.15 MaxDD -24.58% Jarque-Bera 1966.49*** Ljung-Box 8.51*** ACF(1) -0.05 Alpha (Annualized) 2.34% Beta 0.37*** Breusch-Pagan 0.04 Breusch-Godfrey 12.64*** Jarque-Bera (Residuals) 4365.3*** Trading Prot & Loss $23,874.81 Total Commissions Paid ($1,164) Mean Slippage -0.26% StDev Slippage 0.15% Number of Trades 161 Average Holding Period 407.52 Mean Trade Return 28.27% StDev Trade Return 39.59%

Buy & Hold $53,743.67 $7,624.32 $137.75 ($8,987.34) 8.55% 21.26% 0.35 1.16 -57.81% 9721.38*** 19.96*** -0.08 0.60% 0.96*** 2.53 0.28 117015161.65*** $29,968.94 ($2,240.4) -0.27% 0.16% 23 4228.00 53.90% 58.73%

Momentum (Scaled) $39,389.95 $4,371.57 $591.59 ($7,729.26) 4.69% 12.39% 0.29 1.14 -26.65% 6687.39*** 15.27*** -0.07 0.86% 0.38*** 3.57* 16.2*** 6482*** $17,156.04 ($858.5) -0.25% 0.15% 97 673.51 35.83% 48.57%

Table 6: Performance statistics for the Absolute Momentum (AM) strategy with quarterly rebalancing and $25,000 starting capital for the period of October 3, 2001 through May 1, 2013. *** signicant at 1% level, ** signicant at 5% level and * signicant at 10% level.

23

Momentum Model Terminal Wealth $38,583.03 Total Dividends $5,982.29 Total Interest $98.07 Total Fees Paid ($7,621.41) Annualized Return 5.69% Annualized Volatility 20.68% Sharpe Ratio 0.22 Omega 1.12 MaxDD -57% Jarque-Bera 3796.16*** Ljung-Box 21.32*** ACF(1) -0.09 Alpha (Annualized) -1.81% Beta 0.90*** Breusch-Pagan 5.6** Breusch-Godfrey 27.85*** Jarque-Bera (Residuals) 4055.28*** Trading Prot & Loss $15,124.09 Total Commissions Paid ($8,007.45) Mean Slippage -0.27% StDev Slippage 0.19% Number of Trades 369 Average Holding Period 119.48 Mean Trade Return 8.08% StDev Trade Return 15.78%

Buy & Hold $52,892.72 $7,530.09 $146.79 ($8,884.08) 8.42% 21.31% 0.34 1.16 -58.03% 10035.85*** 20.05*** -0.08 0.46% 0.96*** 2.95* 0.26 129174755.55*** $29,099.91 ($2,369.1) -0.29% 0.22% 23 4228.00 35.65% 42.15%

Momentum (Scaled) $33,325.94 $5,938.25 $103.03 ($7,096.18) 4.33% 20.21% 0.16 1.16 -62.19% 7613.2*** 16.52*** -0.08 -3.1%* 0.89*** 0.36 13.6*** 5909.42*** $9,380.84 ($5,387.9) -0.27% 0.19% 257 171.55 9.18% 17.96%

Table 7: Performance statistics for the Cross-Sectional Momentum (CM) strategy with monthly rebalancing and $25,000 starting capital for the period of October 3, 2001 through May 1, 2013. *** signicant at 1% level, ** signicant at 5% level and * signicant at 10% level.

24

Momentum Model Terminal Wealth $44,276.25 Total Dividends $6,799.67 Total Interest $89.18 Total Fees Paid ($8,420.81) Annualized Return 6.96% Annualized Volatility 21.03% Sharpe Ratio 0.28 Omega 1.14 MaxDD -58.98% Jarque-Bera 4149.34*** Ljung-Box 17.49*** ACF(1) -0.08 Alpha (Annualized) -0.68% Beta 0.92*** Breusch-Pagan 6.50** Breusch-Godfrey 27.44*** Jarque-Bera (Residuals) 3244.2*** Trading Prot & Loss $20,808.21 Total Commissions Paid ($5,538) Mean Slippage -0.28% StDev Slippage 0.16% Number of Trades 202 Average Holding Period 217.99 Mean Trade Return 9.32% StDev Trade Return 21.07%

Buy & Hold $53,743.67 $7,624.32 $137.75 ($8,987.34) 8.55% 21.26% 0.35 1.16 -57.81% 9721.38*** 19.96*** -0.08 0.60% 0.96*** 2.53 0.28 117015161.65*** $29,968.94 ($2,240.4) -0.27% 0.16% 23 4228.00 53.90% 58.73%

Momentum (Scaled) $42,005.43 $6,634.06 $97.03 ($7,885.52) 6.35% 20.31% 0.26 1.18 -60.75% 7415.53*** 17.18*** -0.08 -1.12% 0.89*** 0.27 16.33*** 6320.05*** $18,159.85 ($4,089.3) -0.26% 0.14% 156 282.85 10.74% 22.26%

Table 8: Performance statistics for the Cross-Sectional Momentum (CM) strategy with quarterly rebalancing and $25,000 starting capital for the period of October 3, 2001 through May 1, 2013. *** signicant at 1% level, ** signicant at 5% level and * signicant at 10% level.

25

Momentum Model Terminal Wealth $53,747.15 Total Dividends $6,358.33 Total Interest $458.16 Total Fees Paid ($9,105.93) Annualized Return 7.9% Annualized Volatility 15.98% Sharpe Ratio 0.42 Omega 1.13 MaxDD -26.10% Jarque-Bera 1958.27*** Ljung-Box 21.33*** ACF(1) -0.09 Alpha (Annualized) 3.160% Beta 0.51*** Breusch-Pagan 1.64 Breusch-Godfrey 26.19*** Jarque-Bera (Residuals) 8707.46*** Trading Prot & Loss $31,036.59 Total Commissions Paid ($6,219.5) Mean Slippage -0.25% StDev Slippage 0.16% Number of Trades 333 Average Holding Period 111.17 Mean Trade Return 8.58% StDev Trade Return 13.69%

Buy & Hold $52,892.72 $7,530.09 $146.79 ($8,884.08) 8.42% 21.31% 0.34 1.16 -58.03% 10035.85*** 20.05*** -0.08 0.46% 0.96*** 2.95* 0.26 129174755.55*** $29,099.91 ($2,369.1) -0.29% 0.22% 23 4228.00 35.65% 42.15%

Momentum (Scaled) $45,507.12 $5,887.12 $395.17 ($8,043.96) 6.19% 14.29% 0.35 1.14 -31.13% 2432.56*** 14.38*** -0.07 1.82% 0.46*** 0.41 14.64*** 5801.64*** $22,268.8 ($3,581.05) -0.24% 0.15% 218 159.97 9.50% 15.19%

Table 9: Performance statistics for the Cross-Sectional, Absolute Momentum (CAM) strategy with monthly rebalancing and $25,000 starting capital for the period of October 3, 2001 through May 1, 2013. *** signicant at 1% level, ** signicant at 5% level and * signicant at 10% level.

26

Momentum Model Terminal Wealth $59,867.75 Total Dividends $7,118.02 Total Interest $424.18 Total Fees Paid ($9,858.6) Annualized Return 8.84% Annualized Volatility 16.05% Sharpe Ratio 0.48 Omega 1.14 MaxDD -26.13% Jarque-Bera 2033.82*** Ljung-Box 14.91*** ACF(1) -0.07 Alpha (Annualized) 4.08% Beta 0.51*** Breusch-Pagan 0.62 Breusch-Godfrey 22.07*** Jarque-Bera (Residuals) 7966.33*** Trading Prot & Loss $37,184.16 Total Commissions Paid ($3,452) Mean Slippage -0.26% StDev Slippage 0.16% Number of Trades 175 Average Holding Period 206.70 Mean Trade Return 10.70% StDev Trade Return 19.58%

Buy & Hold $53,743.67 $7,624.32 $137.75 ($8,987.34) 8.55% 21.26% 0.35 1.16 -57.81% 9721.38*** 19.96*** -0.08 0.60% 0.96*** 2.53 0.28 117015161.65*** $29,968.94 ($2,240.4) -0.27% 0.16% 23 4228.00 53.90% 58.73%

Momentum (Scaled) $44,931.13 $5,639.73 $349.07 ($7,825.25) 6.08% 14.30% 0.35 1.15 -30.27% 1714.99*** 13.83*** -0.07 1.66% 0.46*** 0.00 12.54*** 5657.68*** $21,767.58 ($2,148.9) -0.25% 0.14% 136 259.44 9.79% 19.17%

Table 10: Performance statistics for the Cross-Sectional, Absolute Momentum (CAM) strategy with quarterly rebalancing and $25,000 starting capital for the period of October 3, 2001 through May 1, 2013. *** signicant at 1% level, ** signicant at 5% level and * signicant at 10% level.

27

Figure 1: Omega(0) statistics of varying thresholds, U = {1, ..., 23}, for the Cross-Sectional Momentum (CM) strategy with monthly rebalancing and employing our momentum model. The trendline represents the Omega(0)=1.1216 for the strategy using our DT(IHH) algorithm.

Figure 2: Omega(0) statistics of varying thresholds, U = {1, ..., 23}, for the Cross-Sectional Momentum (CM) strategy with quarterly rebalancing and employing our momentum model. The trendline represents the Omega(0)=1.1359 for the strategy using our DT(IHH) algorithm.

28

Figure 3: Omega(0) statistics of varying thresholds, U = {1, ..., 23}, for the Cross-Sectional, Absolute Momentum (CAM) strategy with monthly rebalancing and employing our momentum model. The trendline represents the Omega(0)=1.1290 for the strategy using our DT(IHH) algorithm.

Figure 4: Omega(0) statistics of varying thresholds, U = {1, ..., 23}, for the Cross-Sectional, Absolute Momentum (CAM) strategy with quarterly rebalancing and employing our momentum model. The trendline represents the Omega(0)=1.1439 for the strategy using our DT(IHH) algorithm.

29

30

Annualized Return Annualized Volatility Sharpe Ratio Omega MaxDD Alpha (Annualized) Beta Number of Trades Average Holding Period Mean Trade Return StDev Trade Return

CM Monthly DT(IHH) DT(HH) 5.69% 5.62% 20.68% 21.23% 0.22 0.21 1.12 1.14 -57.00% -57.03% -1.81% -2.16% 0.90*** 0.94*** 369 384 119.48 139.96 8.08% 6.21% 15.78% 17.32%

CM Quarterly DT(IHH) DT(HH) 6.96% 6.89% 21.03% 21.23% 0.28 0.27 1.14 1.14 -58.98% -58.74% -0.68% -0.90% 0.92*** 0.94*** 202 194 217.99 277.67 9.32% 8.25% 21.07% 20.73%

CAM Monthly DT(IHH) DT(HH) 7.90% 6.81% 15.98% 15.25% 0.42 0.37 1.13 1.15 -26.10% -24.45% 3.16% 2.31% 0.51*** 0.48*** 333 378 111.17 111.04 8.58% 7.75% 13.69% 12.86%

CAM Quarterly DT(IHH) DT(HH) 8.84% 6.63% 16.05% 15.12% 0.48 0.36 1.14 1.15 -26.13% -29.32% 4.08% 2.16% 0.51*** 0.47*** 175 182 206.70 220.63 10.70% 10.50% 19.58% 17.78%

Table 11: Comparison of rank-based strategies using the momentum model which either employ the Dynamic Threshold (Inverse Herndahl-Hirschman) [DT(IHH)] or Dynamic Threshold (Herndahl-Hirschman) [DT(HH)] to determine the rank threshold. *** signicant at 1% level, ** signicant at 5% level and * signicant at 10% level.

Figure 5: Equally-weighted index values for the period of October 3, 2001 through May 1, 2013 with a starting value of 1.

Figure 6: Threshold values using the Dynamic Threshold (Inverse Herndahl-Hirschman) at a monthly frequency for the period of October 3, 2001 through May 1, 2013.

Figure 7: Threshold values using the Dynamic Threshold (Herndahl-Hirschman) at a monthly frequency for the period of October 3, 2001 through May 1, 2013.

31

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