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Active momentum trading versus passive 'naive diversification’

Article  in  Quantitative Finance · May 2013

DOI: 10.1080/14697688.2013.766760

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Active Momentum Trading versus Passive "1/N Naive Diversi cation"
Anurag N. Banerjee1 , Chi-Hsiou D. Hung2;
1
Durham Business School, Durham University, Durham
2
Division of Accounting & Finance, School of Business, University of Dundee, Dundee
JEL classi cation: G11; G12; G14
Keywords: Momentum strategy; Naive diversi cation; Equally weighted portfolio

*Corresponding author. Tel.: +44 1382 386 702; fax: +44 1382 388421.
E-mail addresses: a.n.banerjee@durham.ac.uk (A. N. Banerjee), c.d.hung@dundee.ac.uk (C.-H.
D. Hung).
Abstract
1
We consider a passive N
naive diversi cation strategy (NDS) which is long in the equally-
weighted portfolio of stocks feasible for trading and short in the risk-free asset. These two
strategies are independent of each other. We examine the pro tability, risk exposures, idiosyn-
cratic variance as well as the relation between the momentum and NDS from the same set of
sample stocks for 1926-2005, divided into various sub-samples by periods and stock sizes. Both
strategies generate an average pro t of 1% per month. The di erences in pro ts are insigni cant
but idiosyncratic variance of the momentum strategies is 20 times higher than NDS.
JEL classi cation: G11; G12; G14
Keywords: Momentum strategies; Naive diversi cation; Equally weighted portfolio; Active
portfolio management; Passive portfolio management
1 Introduction

Asset managers in the stock market either opt for active or passive portfolio strategies. One

important strategy involving active trading is the return-based momentum strategy that buys

recent winner stocks and sells short loser stocks (Jegadeesh and Titman (1993 and 2001)). The

extensive evidence of the pro tability of momentum trading has undoubtedly underpinned the

interests of investment practitioners. Many studies demonstrate the statistically signi cant

model alpha of the momentum pro t using either the CAPM or multi-factor models (see, for

example, Fama and French (1996), Avramov and Chordia (2006), Sagi and Seasholes (2007),

Liu and Zhang (2008)). Korajczyk and Sadka (2004) further show that after controlling for

transaction costs the momentum strategies remain pro table.

In contrast, the formation of an equally weighted stock portfolio is widely adopted among

passive portfolio managers. Benartzi and Thaler (2001), for example, document this simple

1
N
rule for allocating wealth across assets. DeMiguel, Garlappi and Uppal (2009) denote the

1 1
N
allocation rule as a "naive diversi cation strategy" and show that the pro ts of the N
rule

is comparable to "optimal" portfolio strategies. Huberman and Jiang (2006) nd that 401(k)

participants tend to allocate their contributions evenly across their selected funds. Benartzi

and Thaler (2007) examine the asset allocation behavior for retirement savings funds and

provide evidence that "investors are relatively passive ... and they adopt naive diversi cation

strategies".

Banerjee and Hung (2011) provide a new methodology to evaluate the performance of an

active momentum \asset manager". Their method rewards and penalizes the momentum strate-

gist for using the past return information in the formation of the strategies. To this end, they

construct the "naive investors" who use no information and weight risky assets randomly.

Overall, they nd that over the long-run the rewards and penalties cancel out and that the

momentum strategist is no better than a simple "naive" randomizer. One interesting outcome

1
of the construction of this universe of naive investors is that the median naive investor follows

1 1
the "naive diversi cation strategy" or the N
allocation rule. Essentially, such a N
allocation

rule is a passive strategy which tracks the equally weighted stock portfolio without using past

information.

In this paper, we aim to understand the merits and demerits of the active momentum trading

1
and this passive N
strategy. For this purpose we examine their raw and risk-adjusted pro ts

and idiosyncratic variances (in other words the variance of returns due to stock selection (see,

Sharpe (1992)). We further investigate the relation between these strategies in terms of their

correlation and the dimensions of risk exposures.

We consider a naive diversi cation strategy (N DS, thereafter) which is long in the equally

weighted ( N1 ) portfolio of stocks and short in the risk-free asset at the beginning of a period.

This creates an initial zero net-worth position as in the momentum strategies. The returns

1
on the N
portfolio in excess of the risk-free rate, using the one-month Treasury bill rate as

a proxy, are thus the pro ts of the zero net-worth strategies of the N DS. At the end of the

period the N DS rebalances the stock portfolio in order to remain equally weighted. The N DS

then holds the portfolio for the next period and continues to get nanced at the risk-free rate.

This strategy can be practically implemented and tracked over time.

The momentum strategies (M S, thereafter) rst form portfolios of the winner (top 10%

past returns) and the loser (bottom 10% past returns) stocks and then hold a long position

on the winner portfolio and a short position on the loser portfolio. The momentum strategies

further execute intensive trading in order to establish overlapping strategy positions.

We use the monthly equity data of the NYSE, AMEX and NASDAQ over the sample period

between 1926 and 2005, various sub-sample periods and 100 randomly selected ten-year periods.

The set of sample stocks that we use to construct the equally weighted portfolio is the same as

that for constructing the momentum strategies. We nd that the average pro t of the N DS

is around 1% per month, close to that of the M S, in our sample period and in the sub-sample

2
periods of Jegadeesh and Titman (1993 and 2001). The M S generates the same level of pro ts

as the N DS during the period of bull markets such as the dot-com bubble and make pro ts

from selling short the losers in the great depression period. Further, we divide the sample into

two groups of large and small size stocks for the various sub-sample periods and nd that, in

each size group, the di erence between the average pro ts of the N DS and the M S is close to

zero and statistically insigni cant.

Moreover, the variance of the idiosyncratic component of the momentum pro ts is 20 times

higher than the N DS pro ts. Importantly, the risk-adjusted alpha of the di erence in pro ts

between the momentum and the N DS is virtually zero and statistically insigni cant. The N DS

and the momentum strategies are orthogonal, i.e., that their pro ts have zero correlation. The

momentum pro ts show a positive market beta and a signi cant loading of nearly 1 on the

momentum factor. In contrast, the N DS has a signi cantly positive market beta, but does not

have signi cant exposure on the momentum factor.

On a risk-adjusted basis, the winners outperform the N DS by 14 basis points per month,

while the losers under-perform the N DS by 18 basis points per month. The results, taken

together, suggest that asset managers might be able to earn higher risk-adjusted excess returns

than the N DS by either taking a long position in the winner portfolio, or by taking a short

position in the loser portfolio. The M S, however, are not better o pursuing the combined

long-short trading because a simple strategy which equally weights the feasible set of stocks can

achieve the same level of average pro t, either raw or risk-adjusted,as the momentum strategies,

but with lower idiosyncratic variance.

Our ndings are robust with respect to sampling or period-speci c e ects as we simulate

the distributions of the average returns of the winner and the loser portfolios as well as the

momentum pro ts by re-sampling with replacements. In each of the 100 randomly chosen

ten-year period we use all stocks feasible for trading in the sample during that period, and

then construct the empirical distribution of the average pro ts. At the 5% level all of the 100

3
samples accept the null hypothesis that the momentum pro ts are equivalent to the pro ts of

the N DS. We further consider the momentum strategies based on 12-month formation and

12-month holding periods as in Jegadeesh and Titman (1993). Overall, our results still hold,

showing that the use of adopting the naive 1=N diversi cation is a good investment policy

relative to the 12-month momentum strategies.

Our ndings are important for practitioners and investors. The results illustrate that the

M S requires the analysis of past return information and then takes both sides of the extreme

return positions, thereby taking up the risk from the tails of the return distribution. By doing

so, they signi cantly reduce the exposure to the market risk but face large dispersions in the

pro ts.

The N DS, by contrast, simply weights stocks equally and performs as well as the M S,

and even has lower idiosyncratic variance. From a practical point of view pursuing the active

momentum strategies would not be bene cial once further taking into account of the costs of

the intensive long-short trading, the risks and regulation restrictions on short sales of stocks1 .

The rest of the paper is structured as follows. Section 2 de nes the naive diversi cation

strategy and the momentum strategies. In Section 3 we examine the pro tability of these

strategies over the whole sample period, some interesting sub-sample periods, and 100 randomly

selected 10-year periods. Section 4 analyzes the theoretical and empirical relations between the

1
momentum and the N
naive diversi cation strategies, risk factor exposures and idiosyncractic

variance. Section 5 concludes.

1
Jones and Lamont (2002), for example, describe the di culties of short sales including the risks, costs, legal
and institutional restrictions, and the need of su cient stock supply from investors who are willing to lend.

4
2 The Naive 1/N Diversi cation Strategy and the Mo-

mentum Strategies

We de ne N stocks that are feasible for trading at a given month as in Jegadeesh and Titman

(1993). The set of N stocks we use for forming the N DS strategies is in fact the same as the

set of stocks for forming the momentum strategies. Speci cally, we use all the monthly equity

data of the New York Stock Exchange (NYSE), the American Stock Exchange (AMEX) and

NASDAQ les from the Center for Research in Security Price (CRSP) for the period between

January 1926 and December 2005. We includes all stocks classi ed as ordinary common shares

(CRSP share codes 10 and 11) with exchange codes of 1, 2 and 3 as of the end of the previous

year. We thus exclude all non-common equities such as American deposit receipt, companies

incorporated outside of the U.S., shares of bene cial interests, certi cates, real estate investment

trusts, close-end funds,...etc. A stock must meet the following criteria in order to be included

for analysis: First, a stock must have observations on returns for the current month and over

the past 6 or 12 months (depending on the respective analysis period), stock price, and shares

outstanding. Second, a stock must have a price equal to or higher than $5 at portfolio formation.

Our tests focus on the representative overlapping momentum strategies that form portfolios

by sorting stocks on their past 6-month compounded returns and hold portfolios for 6 months.

At the end of each month, the stocks within the top 10% of past returns comprise the winner

portfolio FW ; and stocks within the bottom 10% of past returns comprise the loser portfolio FL .

Portfolios are equally weighted at formation and are held for six months without rebalancing

during the holding period2 . The momentum strategy is then de ned as FP = (FW FL ) :

Denote r = [r1 ; r2 ; :::; rN ] as the vector of returns on the feasible stocks in excess of the risk-

free rate rf : We compute monthly excess portfolio returns (rW = r0 FW and rL = r0 FL ) and the

pro ts, rP = r0 FP to the momentum strategies using single-period returns as in Liu and Strong
2
In the case when a stock is delisted during the holding period, the liquidating proceeds are reinvested in
the remaining stocks in the portfolio.

5
(2008). The momentum strategies have six overlapping strategy positions with each starting

one month apart. The monthly portfolio returns from the overlapping strategies are averages

of the six strategies as in Jegadeesh and Titman (1993).

We construct the ` N1 naive diversi cation strategy' over these N feasible stocks. The excess

1
PN
portfolio returns from the strategy N
1 = [ N1 ; N1 ; :::; N1 ] is then given by r = 1
N i=1 ri. ; where

1
r is e ectively the pro t of the N
naive diversi cation strategy. Banerjee and Hung (2011)

demonstrate that this strategy does not involve information costs and is the cross-sectional

mean and the projection median of their uniformly distributed random strategies.

3 Pro tability of the Strategies

The top panel in Figure 1 plots the time-series of pro t di erences between the momentum

and the N DS strategies. The pro t di erences mainly center around zero and exhibit sporadic

deviations from zero most of the time. During the periods from 1929 through 1933 and in the

late 90s, however, there exist large positive and negative deviations. These periods correspond,

respectively, to the great depression and the dot-com bubble. We thus carefully examine these

sub-sample periods.

[Insert Figure 1 here]

Panel A of Table 1 presents the average excess returns of the winner and the loser portfolios,

the average momentum pro ts as well as the average di erences in excess returns between these

portfolios and the N DS. The winner and the loser portfolios have average excess returns of

1.78% and 0.70% per month, respectively. The momentum strategies generate a statistically

signi cant average pro t of 1.08% per month. Strikingly, the average pro t of the N DS is

as high as 1.06% per month and is highly signi cant. The winner portfolio outperforms the

N DS by a statistically signi cant 0.72% per month, while the loser portfolio under-performs

the N DS by a statistically signi cant 0.36% per month. Importantly, the average di erence

6
between the pro ts of the momentum and the zero net-worth N DS strategies is virtually zero

and statistically insigni cant.

[Insert Table 1 here]

We next look into the question of whether size matters in our analysis. For this purpose,

we divide the sample, each month, into two groups of large and small size stocks using the

median of the market value of all sample stocks at the end of the previous month as the cut-o

point. We then form the momentum and the zero net-worth N DS strategies within each of the

groups. Panel A of Table 2 shows that, in each size group, the di erence between the average

pro ts of the momentum and the N DS strategies is close to zero and statistically insigni cant.

Within the sample of small size stocks, the average monthly momentum pro t is 5 basis points

lower, but statistically insigni cant, than that of the N DS; within the sample of large size

stocks, the average momentum pro t is 11 basis points higher, but statistically insigni cant,

than that of the N DS.

[Insert Table 2 here]

3.1 Over Sub-Sample Periods

1
Next, we examine the pro tability of the momentum and the N
naive diversi cation strategies

over the sample periods of Jegadeesh and Titman (1993 and 2001) from 1965 to 1989 and

from 1990 to 1998, respectively. Panel B of Table 1 shows that over the former sub-period

the momentum strategies generate a statistically signi cant average pro t of around 1.1% per

month. The N DS has a statistically signi cant average monthly pro t of 0.9%. The average

di erence in pro ts between the momentum and the N DS strategies is 0.18%, but statistically

insigni cant. Comparing with the N DS, the winner portfolio signi cantly outperforms by

0.72%, while the loser portfolio signi cantly under-performs by 0.36% per month. The results

in Panel C of Table 1 for the latter subperiod are similar. Again, there is virtually no di erence

7
in pro ts between the momentum and the N DS strategies. The middle panels in Figure 1

plots the di erences in pro ts between the momentum and the N DS strategies over the sample

periods of Jegadeesh and Titman (1993 and 2001). The pro t di erences mainly center around

zero and only exhibit sporadic deviations from zero.

As discussed earlier, we observe large pro t di erences between the momentum and the

N DS strategies in the early and later periods of our sample. We therefore further examine

the sub-sample periods between August 1929 and March 1933 during the great depression as

designated by the NBER and between January 1995 and March 2000 for the dot-com bubble.

Interestingly, we nd that during the great depression period, as shown in Panel D of Table

1, the winner portfolio loses 1.69% per month, but the loser portfolio incurs an even larger

average monthly loss of -2.41%. The average momentum pro t of 0.72%, although statistically

insigni cant, mainly comes from the short position on the loser portfolio. The N DS also su ers

an average monthly loss of -2.02%. The average of the excess returns on the winner portfolio is

only 33 basis points higher than the average pro t of the N DS, but statistically insigni cant.

The average di erence in pro ts between the momentum and the N DS investing, although as

high as 2.74%, but is statistically insigni cant because of higher volatility in this period. The

right-hand panel in the lower part of Figure 1 shows that the pro t di erences over this period

display a few very large negative outliers.

Panel E of Table 1 shows that during the dot-com bubble period the winner portfolio has

an average monthly excess return of 3.96% which is 2.37% higher than that of the N DS. The

average excess return on the loser portfolio is 48 basis points lower than the N DS, albeit sta-

tistically insigni cant. The average di erence between the pro ts of the momentum and the

N DS strategies is 1.27%, but statistically insigni cant. The left-hand panel in the lower part

of Figure 1 shows that the pro t di erences over this period mostly center around zero. The

results in panels B, C, D and E of Table 2 show that, in these sub-sample periods, the di er-

ences between the average pro ts of the momentum and the N DS strategies are statistically

8
insigni cant in both the large and small size groups.

Overall, the momentum strategies do not outperform the N DS in all the periods considered.

The evidence suggests that, on average, an investor would be better o if he holds, each month,

a portfolio of all feasible stocks with equal weights which is nanced by borrowing at the risk-

free rate. This is because this passive investing strategy generates equivalent average pro t and

does not require sophisticated trading as do the momentum strategies.

3.2 100 Randomly Selected 10-Year Periods

We design a simulation experiment to see whether the momentum strategies outperform the

N DS in any given period and any given set of assets. For each run, we select an experiment

period of 120 months with the starting month randomly chosen between July 1926 and Decem-

ber 1995. We then use all sample stocks in that period and the portfolio formation methods

described earlier to form the momentum strategies and the N DS. The set of sample stocks

that are used to construct the equally weighted portfolios is the same as that for constructing

the momentum portfolios.

We draw 100 samples with replacements and obtain 100 sample averages for monthly excess

returns of each of the winner and the loser portfolios as well as the pro ts of both the momentum

and the N DS strategies.

We compute average excess returns of the momentum portfolios and an average monthly

pro t of the zero net-worth N DS over the 120 months. We test, for each sample, the null

hypothesis H0 : E [rP ] = E [r] against the alternative H1 : E [rP ] > E [r] using the T = 120

monthly pro ts of the momentum and the N DS strategies using the following t-statistic:

p rPs rs
ts = T ; s = 1; ::100
stds (rP r)

where rPs ; rs and stds (rP r) are the average momentum pro t, the average pro t of the N DS

9
strategies and the standard deviation of the di erence in pro ts between momentum and N DS

strategies, respectively, for the randomly chosen sample period s: We reject the null at the %

signi cance level when ts > t ; and count the number of non-rejections to indicate the number

of periods when momentum strategies signi cantly outperform N DS strategies. We nd that

at the 5% level none of the 100 samples rejects the null and, at the 10% level only 4 out of the

100 samples reject the null.

Figure 2 presents the distributions of these sample averages. The modes of average returns

of the winner, the loser portfolios and the momentum pro ts are 1.83%, 0.69% and 1.19%,

respectively. The average pro ts of the N DS have a mode of 1.18%. We also observe that by

95% of the time the N DS gives statistically positive pro ts whereas the corresponding gures

for the winner portfolio, the loser portfolio and the momentum pro ts are 100%, 87% and 95%,

respectively. The di erences in pro ts between the momentum and the N DS strategies have a

mode of 0.06 with 53% chance being positive. Hence, the 1=N diversi er is almost as good as

the momentum strategist.

[Insert Figure 2 here]

1
4 The Relation between the Momentum and the N Di-

versi cation Strategies

1
We analyze the theoretical relation between the momentum and the N
naive diversi cation

strategies by assuming that for every period t, the cross-section of excess returns are charac-

terized by a factor model:

rt = t + Bt xt + "t ; "t ' N 0; t2 INt ; t = 1; :::; T (1)

10
where t =[ 1t ; :; it; ::; Nt t ], Bt = [ 1t ; ::; it ; :::; N t] is the vector of factor loadings, x0t s are

2
common risk factors, t is the idiosyncratic variance at time t and Nt is the total number of

assets at time t.

2 1
The idiosyncratic variance of N DS is simply V ar (rt j xt ) = t Nt : Also note that Cov rjt ; r0 1 N1t xt

2 0 1 2 1
= t Fjt 1 Nt = t Nt ; j = W; L. Therefore, it is easy to see that the conditional mean of the

excess returns on the winner and loser portfolios can be given by

1
E (rjt j xt ;rt ) = ( t + Bt xt )0 F0jt + rt ( t + Bt xt )0 1
Nt

10
Since Fjit = Nt
; if ith asset is in the winner portfolio, we get the idiosyncratic variance as

2 2 10
V ar (rjt j x;r) = F0jt Fjt = t :
Nt

Therefore it immediately follows that the conditional mean and idiosyncratic variance of the

momentum pro ts are:

E[rP t ( t + Bt x)0 FP xt ;rt ] = 0; and (2)

2 20
V ar[rP t j xt ] = t (3)
Nt

The above results suggest theoretical relations that: 1) the momentum strategies and N DS

are orthogonal to each other, and 2) the idiosyncratic variance of pro ts is 20 times higher than

the idiosyncratic variance of the N DS. We test these predictions below.

4.1 Orthogonality

Under the assumptions made in the factor model of (1) and from (2), the pro ts of the mo-

1
mentum strategies are orthogonal to the pro ts of the N
naive diversi cation strategies. We

11
examine this prediction by plotting the excess returns on the winner portfolio, the loser port-

1
folio and the momentum pro ts against the N
naive diversi cation strategies (r) in Figure 3.

The scatter-plot shows that the slope coe cients for both rW and rL seem to be close to one

and that the the momentum pro ts are randomly scattering against r.

[Insert Figure 3 here]

p
Formally, we run a weighted (by bt2 =Nt ) linear regression (WLS) of the momentum pro ts

on the pro ts of the N DS. Speci cally, we examine the following time series model to test the

null H0 : P = 0,

2
t
rjt = j + j rt + ujt ; t = 1; :::T; j 2 fW; L; P g and V ar (ujt ) /
Nt

2
where t is the variance of "t in (1), and Nt is the total number of assets at time t:

The WLS results show a bP of -0.04 (t = 0.43) which is in line with the predictions of (2)

and suggests that the momentum pro ts are orthogonal to the pro ts of the N DS. We also

test whether the sensitivities of the winner and the loser portfolios on the N DS are statistically

di erent from one: We run WLS regressions of excess portfolios returns on the pro ts of the

N DS to test the null of H0 : W = L = 1. The results show that bW = 0:85 and bL = 0:81;

both are lower than one with t = -1.91 and t = -2.52, respectively.

4.2 Risk-Adjusted Pro ts and Risk Exposures

1
We examine the risk-adjusted pro ts and risk factor exposures of the momentum and the N

naive diversi cation strategies. Speci cally, we run the time-series regression,

rjt = j + j M KTt + sj SM Bt + hj HM Lt + mj M OMt + vjt ; j 2 fW; L; P; N DSg (4)

12
where rjt is the excess portfolio return or pro t on strategy j at time t. M KT is the return

on the CRSP value-weighted market index at time t in excess of the one month T-bill rate.

The Fama-French (1993) size factor, SM B, is de ned as the monthly return di erence between

two portfolios that consist of large and small stocks. The Fama-French value factor, HM L, is

de ned as the monthly return di erence between the two portfolios with high and low book-to-

market equity ratio. The momentum factor, M OM , is the monthly return di erence between

the two portfolios with high and low returns over the past 2 to 12 months.3 The coe cients

sj , hj and mj are the loadings on the size, value and the momentum factors, respectively.

[Insert Table 3 here]

Table 3 shows the regression results for the entire sample period. The Newey-West standard

errors are applied to correct for heteroskedasticity and autocorrelation of residuals. Panel A

shows that both the winner and loser portfolios are signi cantly exposed to the market, SM B

and momentum factors. The momentum strategies have an average risk-adjusted pro t of

0.3% per month and are marginally exposed to the market factor and with a highly signi cant

loading of nearly 1 on the momentum factor, but with insigni cant loadings on the SM B and

HM L factors. The N DS has a highly signi cant alpha of 0.25% per month with statistically

signi cant loadings of 1.05, 0.42 and 0.09, respectively, on the market, SM B and HM L factors.

The N DS does not have signi cant exposure on the M OM factor. Thus the momentum and the

N DS bear di erent sources of risk. After accounting for the factor exposures, the magnitude

of the risk-adjusted momentum pro t is close to that of the N DS.

Panel B of Table 3 shows that the di erences between the excess returns of the winner

portfolio and the pro ts of the N DS have a positive and marginally signi cant alpha with

positive and highly signi cant exposures to the market, SM B and M OM , but with a negative

exposure to the HM L factor. The di erences between the excess returns of the loser portfolio
3
The returns on these factors are obtained from Ken French's data library.

13
and the pro ts of the N DS have a negative and marginally signi cant alpha with positive and

highly signi cant exposures to the market and the SM B factor, but with a negative and highly

signi cant exposure to the M OM factor. Importantly, the di erence in pro ts between the

momentum and the N DS has a very small and statistically insigni cant alpha of 7 basis points

per month.

4.3 Idiosyncratic Variance Ratio

We test the null hypothesis that the ratio of idiosyncractic variance (CVR= VVar[ rP t jxt ]
ar( r t jxt )
) between

the momentum pro ts and the N DS pro ts are equal to 20 as is the prediction of (3). Specif-

ically, we test the null hypothesis:

V ar[rP t j xt ]
H0 : = 20.
V ar (rt j xt )

Since the idiosyncractic variance ( t2 ) and the number of assets (Nt ) vary over time, we cannot

use the traditional variance ratio test. We test this hypothesis by constructing a moment based

estimator for the CVR as

1X
T
vb2
CV R = CV Rt where CV Rt = 2 P t
T t=1 vbN DSt

where vbP t and vbN DSt are the residuals from the regressions in (4). Note that

vbP2 t EbvP2 t V ar[rP t j xt ]

E (CV Rt ) = E 2
= 2
= :
vbN DSt Eb
vN DSt V ar (rt j xt )

The second equality follows from Heijmans (1999). Finally, using (3) we obtain the expected

variance ratio. Therefore under the null hypothesis by the central limit theorem, the standard-

14
ized statistic is
p (CV R E (CV R)) D
ZCV R = T ! N (0; 1) : (5)
stdev (CV R)

Under the null hypothesis E (CV R) = 20: We obtain the calculated ZCV R of 1.005 over the

whole sample period, and hence, accept the hypothesis that the idiosyncratic variance of the

momentum portfolio is 20 times higher than the idiosyncratic variance of the N DS.

4.4 Twelve-Month Momentum

For robustness checks, we further consider the momentum strategies based on 12-month for-

mation and 12-month holding periods as in Jegadeesh and Titman (1993). Using exactly the

same criteria for the selection of the stock set, the stocks that are feasible for trading exclude

those whose prices are below $5 at portfolio formation. Consistent with Jegadeesh and Titman

(1993), Panel B of Table 4 reports the average (12-by-12) momentum pro t as 0.63% per month

and statistically signi cant. Panel A for the entire sample period shows that the winner and the

loser portfolios have average excess returns of 1.38% and 1.11% per month, respectively. The

average momentum pro t is 0.28% per month, but statistically insigni cant. The average pro t

of the N DS remains statistically signi cant at 1.04% per month. The momentum strategies

under-perform the zero net-worth N DS strategies by 0.76% per month. The overall pattern of

the results presented in Table 4 shows that momentum strategies do not outperform the N DS

strategies.

[Insert Table 4 here]

Table 5 shows, for the entire sample period, the regression results and the t-statistics using

the Newey-West standard errors. In contrast to the results in Table 3, Panel A of Table 5

shows that the HM L factor becomes statistically signi cant for the winner portfolio, the loser

portfolio and the momentum pro t. Further, the average risk-adjusted return on the winner

15
portfolio is essentially zero and statistically insigni cant, while the alpha of the N DS remains

statistically signi cant at 0.25% per month.

Panel B of Table 5 shows that the model alpha of the di erence between the excess return

on the winner portfolio and the N DS pro t is now negative, re ecting the insigni cant model

alpha of the winner portfolio as shown in Panel A, while the pattern of risk exposures is similar

to that of the 6-month-by-6month momentum. The model alpha of the di erence between the

loser portfolio and the N DS pro t is close to zero and statistically insigni cant. The model

alpha of the di erence in pro ts between the momentum and the N DS is negative 28 basis

points per month and statistically signi cant. Overall, the 12-month momentum strategies

under-perform the N DS strategies.

Overall, our results still hold, and in fact the 12-month momentum strategies under-perform

the NDS strategies, showing that the use of adopting the naive 1/N diversi cation is a good

investment policy relative to the 12-month momentum strategies.

[Insert Table 5 here]

5 Conclusions

In this paper we examine the merits and demerits of the active momentum strategies that use

1
stocks of the top and bottom 10% returns and the passive N
naive diversi cation strategy

which is long in the equally weighted portfolio of stocks and short in the risk-free asset. The

momentum and the N DS strategies are orthogonal. The N DS generates an average pro t

of 1% per month, close to that of the momentum strategies over the sample period between

1926 and 2005, various sub-sample periods including the periods examined in Jegadeesh and

Titman (1993 and 2001). The evidence shows that the di erence in the average pro ts between

the momentum and the N DS strategies are economically and statistically insigni cant. The

ndings are robust with respect to marker capitalization e ects as well as sampling or period-

16
speci c e ects in our simulations where we randomly select 10 years for 100 times. From the

view points of investment, our ndings suggest that pursuing the active momentum trading

1
would not be bene cial relative to the passive N
naive diversi cation strategy.

17
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Banerjee, Anurag and Chi-Hsiou Hung, 2011. Informed Momentum Trading versus Unin-
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Korajczyk, Robert A., and Ronnie Sadka, 2004, Are Momentum Pro ts Robust to Trading
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Risk, Review of Financial Studies 21, 2417-2448.

Liu, Weimin, and Norman Strong, 2008, Biases in Decomposing Holding Period Portfolio
Returns, Review of Financial Studies 21, 2243-2274.

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Journal of Portfolio Management, 7-19.

18
 Table 1
Profitability of the 6-Month Momentum and the 1/N Naive Diversification Strategies
This table presents mean excess returns of the momentum strategies and the 1/N naive diversification strategies (NDS) for the whole sample
period (Panel A), the sub-sample periods of Jagadeesh-Titman (1993 and 2001) (Panels B and C), the periods during the great depression (Panel
D) and the dot-com bubble (Panel E). We use the 1 month T-bill rate as a proxy for the risk-free rate. ‘Winner’ and ‘Loser’ are, respectively, the
returns on the winner and the loser portfolios in excess of the 1 month T-bill rate. ‘Winner – NDS’ and ‘Loser – NDS’ are, respectively, the
return differences between ‘Winner’, ‘Loser’ and the NDS. ‘Momentum Profit – NDS’ is the difference between the profits of the momentum
and the NDS . t-statistics are in parentheses. *, ** and *** denote statistical significance at the 10%, 5% and 1% levels, respectively.
Panel A. The Whole Sample: 01-1927 to 07-2005
Momentum Momentum Profits
Winner Loser NDS Winner – NDS Loser – NDS
Profits – NDS
Mean Return (%) 1.78 0.70 1.08 1.06 0.72 -0.36 0.02
(6.97***) (2.4***) (5.86***) (4.96***) (6.10***) (-2.99***) (0.06)
Panel B. Jagadeesh-Titman (1993): 01-1965 to 12-1989
Mean Return (%) 1.62 0.54 1.13 0.90 0.72 -0.36 0.18
(3.90***) (1.33) (4.68***) (2.64***) (4.40***) (-2.87***) (0.43)
Panel C. Jagadeesh-Titman (2001): 01-1990 to 12-1998
Mean Return (%) 2.22 0.79 1.60 1.34 0.88 -0.54 0.09
(3.41***) (1.32) (4.36***) (3.02***) (3.21***) (-2.17***) (0.18)
Panel D. Great Depression: 08-1929 to 03-1933
Mean Return (%) -1.69 -2.41 0.72 -2.02 0.33 -0.39 2.74
(-1.02) (-0.76) (0.34) (-0.98) (0.42) (-0.27) (0.72)
Panel E. Dot-Com Bubble: 01-1995 to 02-2000
Mean Return (%) 3.96 1.11 2.86 1.59 2.37 -0.48 1.27
(3.13***) (1.21) (3.37***) (2.49***) (2.81***) (-1.27) (1.31)

19
 Table 2
Profitability of 6-Month Momentum and the 1/N Naive Diversification Strategies for Large and Small Size Stocks
This table presents mean excess returns of the momentum strategies and the 1/N naive diversification strategies for the sample periods as
described in Table I. We use the 1 month T-bill rate as a proxy for the risk-free rate. ‘NDS’ is the profit to the NDS . ‘Momentum Profit – NDS’
is the profit difference between the momentum strategies and the NDS . t-statistics are in parentheses. *, ** and *** denote statistical
significance at the 10%, 5% and 1% levels, respectively.
Large Size (greater than the NDS of the market value) Small Size (smaller than the NDS of the market value)
Panel A. The Whole Sample: 01-1927 to 07-2005
Momentum Profits Momentum Profits
Momentum Profits NDS Momentum Profits NDS
– NDS – NDS
Mean Return (%) 0.94 0.83 0.11 1.27 1.32 -0.05
(4.76***) (4.23***) (0.37) (6.98***) (5.52***) (-0.14)
Panel B. Jagadeesh-Titman (1993): 01-1965 to 12-1989
Mean Return (%) 0.80 0.58 0.21 1.47 1.24 0.23
(3.58***) (1.95**) (0.58) (6.41***) (3.32***) (0.52)
Panel C. Jagadeesh-Titman (2001): 01-1990 to 12-1998
Mean Return (%) 1.11 1.00 0.11 2.00 1.37 0.63
(2.95***) (2.28***) (0.20) (5.58***) (2.63***) (1.08)
Panel D. Great Depression: 08-1929 to 03-1933
Mean Return (%) 0.75 -2.08 2.84 0.44 -2.43 2.88
(0.31) (-1.05) (0.70) (0.23) (-1.10) (0.75)
Panel E. Dot-Com Bubble: 01-1995 to 02-2000
Mean Return (%) 3.22 1.48 1.75 2.72 1.72 1.00
(3.02***) (2.41***) (1.58) (3.47***) (2.43***) (1.03)

20
 Table 3
Risk Exposures of the 6-Month Momentum and the 1/N Naive Diversification Strategies
Panel A reports the factor loadings of the excess returns on the winner (‘Winner’) and the loser (‘Loser’) portfolios, the momentum profits and
the NDS for the period from January 1927 to December 2005. ‘Momentum Profit’ is for the strategies that are long in the winner and short the
loser portfolios. Panel B reports the factor loadings of ‘Winner – NDS’, ‘Loser – NDS’ and ‘Momentum Profit – NDS’ that are the differences
between the excess returns of the winner and loser portfolios, the momentum profits and the profits of the NDS, respectively. MKT is the return
on the CRSP value-weighted market index in excess of the one month T-bill rate. SMB is the monthly return difference between two portfolios
that consist of large and small size stocks. HML is the monthly return difference between the two portfolios with high and low book-to-market
equity ratios. MOM is the monthly return difference between the two portfolios with high and low returns over the past 2 to 12 months. The t-
statistics in parentheses are calculated by applying for the Newey-West heteroskedasticity-and-autocorrelation-consistent standard errors. *, **
and *** denote statistical significance at the 10%, 5% and 1% levels, respectively.
Panel A. Excess Returns of the Momentum and the NDS Strategies
Constant MKT SMB HML MOM
Winner 0.0039 1.2230 0.8001 -0.0484 0.5495
(4.85)*** (44.14)*** (10.70)*** (-1.18) (15.17)***
Loser 0.0007 1.1580 0.7992 0.0635 -0.4471
(0.74) (35.89)*** (16.85)*** (1.29) (-12.45)***
Momentum Profit 0.0032 0.0649 0.0010 -0.1119 0.9966
(2.49)** (1.72)* (0.01) (-1.64) (21.51)***
NDS 0.0025 1.0502 0.4251 0.0888 -0.0186
(7.10)*** (96.80)*** (14.50)*** (4.48)*** (-0.88)
Panel B. Return Differences between the Momentum and the NDS Strategies
Winner - NDS 0.0014 0.1728 0.3751 -0.1372 0.5680
(1.72)* (6.66)*** (4.67)*** (-2.93)*** (13.46)***
Loser - NDS -0.0018 0.1079 0.3741 -0.0253 -0.4286
(-1.93)* (3.20)*** (6.59)*** (-0.45) (-11.51)***
Momentum Profit - NDS 0.0007 -0.9852 -0.4241 -0.2007 1.0151
(0.50) (-26.85)*** (-3.93)*** (-2.89)*** (18.63)***

21
 Table 4
Profitability of the 12-Month Momentum and the 1/N Naive Diversification Strategies
This table presents mean excess returns of the momentum strategies (12 month by 12 month) and the 1/N naive diversification strategies (NDS)
for the whole sample period (Panel A), the sub-sample periods of Jagadeesh-Titman (1993 and 2001) (Panels B and C), the periods during the
great depression (Panel D) and the dot-com bubble (Panel E). We use the 1 month T-bill rate as a proxy for the risk-free rate. ‘Winner’ and
‘Loser’ are, respectively, the returns on the winner and the loser portfolios in excess of the 1 month T-bill rate. ‘Winner – NDS’ and ‘Loser –
NDS’ are, respectively, the return differences between ‘Winner’, ‘Loser’ and the NDS. ‘Momentum Profit – NDS’ is the difference between the
profits of the momentum and the NDS. t-statistics are in parentheses. *, ** and *** denote statistical significance at the 10%, 5% and 1% levels,
respectively.
Panel A. The Whole Sample: 01-1928 to 01-2005
Momentum Momentum Profits
Winner Loser NDS Winner – NDS Loser – NDS
Profits – NDS
Mean Return (%) 1.38 1.11 0.28 1.04 0.35 0.07 -0.76
(5.29***) (3.76***) (1.55) (4.79***) (2.70***) (0.56) (-2.42**)
Panel B. Jagadeesh-Titman (1993): 01-1965 to 12-1989
Mean Return (%) 1.28 0.64 0.63 0.83 0.45 -0.19 -0.20
(2.75***) (1.50) (2.45**) (2.33**) (2.22**) (-1.34) (-0.46)
Panel C. Jagadeesh-Titman (2001): 01-1990 to 12-1998
Mean Return (%) 2.36 1.96 0.40 1.71 0.66 0.26 -1.31
(3.14***) (3.42***) (0.96) (4.02***) (1.70*) (1.07) (-2.85***)
Panel D. Great Depression: 08-1929 to 03-1933
Mean Return (%) 1.40 1.28 0.12 1.12 0.28 0.17 -1.00
(1.15) (1.09) (0.21) (1.34) (0.53) (0.33) (-1.04)
Panel E. Dot-Com Bubble: 01-1995 to 02-2000
Mean Return (%) -3.93 -5.08 1.15 -5.11 1.19 0.04 6.26
(-1.03) (-0.72) (0.33) (-0.90) (0.60) (0.02) (0.70)

22
 Table 5
Risk Exposures of the 12-Month Momentum and the 1/N Naive Diversification Strategies
Panel A reports the factor loadings of the excess returns on the (12-month by 12-month) winner (‘Winner’) and the (12-month by 12-month)
loser (‘Loser’) portfolios, the momentum profits and the NDS for the period from January 1927 to December 2005. ‘Momentum Profit’ is for the
(12-month by 12-month) strategies that are long in the winner and short the loser portfolios. Panel B reports the factor loadings of ‘Winner –
NDS’, ‘Loser – NDS’ and ‘Momentum Profit – NDS’ that are the differences between the excess returns of the winner and loser portfolios, the
momentum profits and the profits of the NDS, respectively. MKT is the return on the CRSP value-weighted market index in excess of the one
month T-bill rate. SMB is the monthly return difference between two portfolios that consist of large and small size stocks. HML is the monthly
return difference between the two portfolios with high and low book-to-market equity ratios. MOM is the monthly return difference between the
two portfolios with high and low returns over the past 2 to 12 months. The t-statistics in parentheses are calculated by applying for the Newey-
West heteroskedasticity-and-autocorrelation-consistent standard errors. *, ** and *** denote statistical significance at the 10%, 5% and 1%
levels, respectively.
Panel A. Excess Returns of the Momentum and the NDS Strategies
Constant MKT SMB HML MOM
Winner 0.0010 1.2493 0.7377 -0.1945 0.5280
(1.07) (42.23)*** (9.04)*** (-3.43)*** (12.28)***
Loser 0.0013 1.1573 0.9209 0.2894 -0.1302
(1.01) (27.14)*** (14.19)*** (4.69)*** (-2.43)**
Momentum Profit -0.0002 0.0920 -0.1832 -0.4839 0.6582
(-0.14) (2.26)** (-1.56) (-5.59)*** (11.13)***
NDS 0.0025 1.0498 0.4251 0.0894 -0.0183
(7.03)*** (95.76)*** (14.37)*** (4.46)*** (-0.86)
Panel B. Return Differences between the Momentum and the NDS Strategies
Winner - NDS -0.0015 0.1994 0.3126 -0.2839 0.5463
(-1.55) (6.42)*** (4.08)*** (-4.41)*** (11.47)***
Loser - NDS -0.0013 0.1075 0.4958 0.2000 -0.1119
(-1.03) (2.68)*** (6.02)*** (3.33)*** (-2.32)**
Momentum Profit - NDS -0.0028 -0.9579 -0.6084 -0.5734 0.6765
(-1.68)* (-21.03)*** (-5.71)*** (-6.04)*** (9.64)***

23
24
Figure 1: The distributions of the di erences in pro ts between the momentum and the NDS strategies for the various sample
periods.
25
Figure 2: The distributions of the average pro ts of the NDS and the excess returns of the winner and the loser portfolios
and the momentum pro ts over 100 random sample periods. The di erence in pro ts between the momentum and the N DS strategies
is denoted by Pro t-N DS: For each run of the simulation, we select an experimental period of 120 months with the starting month randomly
chosen between July 1926 to December 1995.
View publication stats
26
Figure 3: Scatter plots of the excess returns on the winner (blue line) and the loser (green line) portfolios and the momentum
pro ts (red line) versus the pro ts of the NDS strategies.