Wednesday, November 09, 2011

What Happened to Momentum?

The total return to Momentum was impressive for many decades. It's a simple strategy, basically going long past winners and short the losers, hoping they continue to win and lose. Interestingly, the past returns should go only up to the prior month, because there's slight mean-reversion at the one-month horizon, so most people use the returns from months t-12 through t-1. This highlights the non-fractal nature of stock returns, in that there's momentum in the data from 3-18 months, but mean-reversion at the shorter and longer frequencies.

Even after discovered by Jegadeesh and Titman in 1992, it seemed to work for another 8 years. Since 2000, however, it hasn't worked (see a decent paper on that here). Using Ken French's replication of this strategy, we see the total return pattern above. Note that while from 1932 through 1943 it stagnated, it seemed Madoff-like in its ascendance from the end of WW2 through 2000.

The big drawdowns in the momentum strategy occurred in the big stock rebounds of July-Aug 1932, and March-Sep 2009. These moves would generate losses of over 50%, which since it generated an 8% annual return, this would probably eliminate any particular portfolio manager--such losses are usually lethal.

Now, these long-term simulations tend to have a bunch of survivorship problem issues, and data prior to 1964 is to be taken with a grain of salt (the database was created then, so its much harder to correct errors when you don't remember how you collected data in real-time). Interestingly, while momentum is considered a real factor by some (eg, the Carhart 4-factor model is the Fama-French 3-factor model plus momentum), Fama has been conspicuously avoided treating momentum as a risk factor, nor trying to explain in theoretically in any way, and just looked at it quizzically. That was rather refreshing, in that it's tempting when you have the status he does to explain everything in your field, but instead he just shrugged.

Above are the December returns. These actually made sense because there was a real story here. The idea was that winners had taxable gains, and so not selling them until January would push off a liability; losers had losses that selling prior to January would lower one's taxes. Thus winners have this absence of selling, losers a greater amount of selling. Alas, since 2003, this pattern too has disappeared. In fact, I actually put the trade in December 2003 based on looking at this data, and got crushed. It was the worst return by far relative to my sample of 25 years that used a different universe than French but was basically the same pattern. I actually emailed Ken French at that time to ask if he had any insight, and he merely emailed back: 'it's risky.' My boss didn't think that was a good answer.

I think this highlights an important point. At any point in time your strategy is susceptible to a draw down that could cost you your client base. You can't just say 'hey, that's risk!' Investors see it as a failure, not a bad draw from the urn of chance. Returns over time are treated very differently than cross-sectional returns because cross sectional returns have covariances and volatilities amenable to statistical optimization; time-series returns are looked at more like datum in a broader strategy of eliminating all the 'losers' at any point in time. If you are in the bottom 10% at any time for any reason, your portfolio probably has hit an 'absorbing barrier.'


Ben said...

This is what we expect from any strategy which uses publicly available information no?

We can turn the information (in Shannon's sense - raw noise/data) into knowledge by expending effort to discover patterns in it - a process which might in principle be done mechanically (though you have argued not), but is at any rate made much more efficient by having a theory/story for why the pattern might be there.

Since this requires effort, the pattern may persist for a while, and you can trade on it.

But once three people have expended that effort, you can't make money trading it because you are bidding aganst them.

And so with risk premium. If there was one once a risk premium, people noticed, and thought "well if we get a diversified portfolio of high-risk products, it will have lower risk but still get the premium". Once enough people do that the risk premium is bid away.

That's what I think anyway.

J. Blo said...

This isn't investing. It's gibberish.

Anonymous said...

How rich are you Mr Falken?
Do you have a public track record?

Anonymous said...

Frankly, anyone looking at the results Eric shows, in particularly the out-of-sample (since academics began focusing on it in the early 1990s), and concludes anything but "momentum is a smashing success" is an idiot. People looking at graphs like that after a bad period that doesn't come close to erasing the out-of-sample evidence, and conclude "don't do momentum", are much of what's idiotic in investing.

Next, spring of 2009 saw perhaps the greatest sharpest reversal of trend ever. Does it fit intuition that a momentum strategy would lose at such a time? Of course it does.

On to Gene Fama. Let's look at DFA the firm he is intimately involved with. They consciously avoid the negative loading on momentum that comes with their value strategy (if one does not act to consciously avoid it). That means they believe in momentum. They might believe it less than one who makes sure they load positively on it, but if you're scared to load negatively on it, you're a believer. This isn't an insult it's a compliment. They are smart. They believe in momentum.

Eric's comments at the end implying that if any strategy is in the bottom 10% at any time then it's not viable, may be true, but it's also nihilistic idiocy as a strategy that doesn't have this happen occasionally DOES NOT EXIST. The investor who can avoid being a moron and look at the long-term (and btw, if you decide you don't buy into momentum then, fine, but saying it can never lose is just dumb), is the one who wins.

Finally, as numerous papers emphasize, a big part of momentum's attraction is it's very negative correlation to value. Looking at its marginal contribution along with a value strategy makes the long-term evidence much much stronger, and the 2009 problem much much smaller.

Jeez if people on this blog can't understand what a long-term positive sharpe ratio strategy looks like, and instead actually advocate not doing a good strategy because, parahrasing, "some time they lose", and even forget to look at it in a portfolio context (i.e., with value) then all hope for a rational universe is gone.

Disappointed in all of you.

Anonymous said...

In addition, the market, value, etc., pretty much any reasonable strategy, have all died at times, do we throw out everything? Wait, I forgot, Eric believes the risk premium is zero. I guess it's all t-bills from here!!

Anonymous said...

How an informed person has the best chance of whipping the averages over the long term:

1.) Find the best cash flow rich companies you can at the best valuations and buy. Portfolio of 12 - 20 is enough. You want the stocks you wish you could borrow the full amount and own at the current price.
2.) Stay away from Glamour/pyramid scheme type stocks
4.) Forget all the useless mumbo studies riddled with hindsight bias, survivorship bias, and egghead disease.

Anonymous said...

Find possibly 12 companies that are reasonably priced with good cash flows? So dumb.

You have read about the Buffett-monkey who typed Hamlet and think you can too. Good luck with that. And if you get sick, leeches are always a good idea.

That you then say avoid looking backwards, when that's all you're doing, is really funny/sad.

The worst reasoning on Earth is usually passed off as luddite common sense.

Ben said...

Idiotic anonymous: 5
Sense: 1

Any system you can operate mechanically (like momentum) will only work **while you are the only one doing it**. In that role you are serving the market by discovering inefficiencies and correcting them. Once the pattern is well known, bidding ensures it ceases to be an inefficiency and you can no longer make money on it.

That's why the risk premium disappeared. That's why the "momentum premium" (to mint a phrase) disappeared. It isn't that it wasn't real, it is that it is only true as long as it isn't widely noticed.

Call it a "Heisenstrategy" or "Heisenpattern" if you like.

If you find something that works, keep it to yourself, and abandon it the first month it fails. Cos, dude, it's gone.

Anonymous said...

Ben, It was possible you were not a total dolt until you said "abandon it the first month it fails."

Are you aware that a true 3 Sharpe strategy fails in a few months every year? A 1 Sharpe strategy fails in many months each year, and you'd be very very rich, instead of a bitter blog poster, if you had one.

No, somehow I think you're not aware...

And of course it's worse when more people do a strategy. But if a strategy exists because it takes a risk, or because there is some set of people with a bias that causes them to do the opposite, it can live in perpetuity at some positive level of risk-adjusted return. That level would be better the fewer who did it, but just because something is known the level doesn't have to go to zero.

I need to go over this. Did you really say to abandon it the first month it fails? Really? I find it hard to believe someone could say that. You think you're so erudite with your little uncertainty principle joke, and then say perhaps the dumbest thing I've heard on markets, and I listened throughout the tech bubbble.

Wow, congrats.

Ben said...

@anon idiot #6:

1. I am not quite as rich as Falkenstein, but doing fine. What about you?

2. Also I am a physicist by training so I own the right to that pun.

3. You have neither listened nor understood.

People drop money all the time. Why aren't the sidewalks littered with dollars?

Because they can only be picked up once.

Anonymous said...

"Find possibly 12 companies that are reasonably priced with good cash flows? So dumb."

You have read about the Buffett-monkey who typed Hamlet and think you can too. Good luck with that. And if you get sick, leeches are always a good idea. "

Just a silly monkey here.... . Yet paying almost no VIG (taxes, trading costs) while invested in low(er) risk stocks that are growing cash flows consistently... It is not that hard to do ok... Particularly relative the huge fraud called the "investment management" (fee skimming) industry.

Anonymous said...

There is nothing wrong with paying no "VIG". But buying 12 companies, instead of a broad-based buy-and-hold index fund, and advocating that as a general policy for investors (whose individual sets of 12 companies sum to something like the the market) is the very very stupid part.

Yep, the solution to high "vig" is massive individual active management (active management is not trading btw, before you yell and scream that your strategy is low turnover, it's differing from the index).

Oh, and the issue wasn't the "VIG", you injected that like all argument cheaters do when they are are losing. The issue was advocating individuals all own 12 stock portfolios.


But, hey, if those 12 stocks are down for a month, you're out of them no?

Anonymous said...

Mr Anon,

-I never advocated a general policy for investors or suggested they all own 12 stocks.

If this was your understanding of my simplistic statement you need to work on your reading comprehension.

The market is to some degree not that different from a pyramid scheme.

There is too much public money chasing too few authentic economic opportunities. In the theoretical world this simply lowers forward returns for all the good index investors, but in the real world it means the majority lose by getting thrown off and enticed back at in at the wrong times.. As Falken has documented here, dollar weighted returns are atrocious. That is reality. What people "should" do does not matter.

I will stick with being a lucky monkey - and when I am not I will be dead.

Anonymous said...

I'm the anonymous calling the other anonymous an idiot for advocating buying 12 stocks with good cash flows (unless that was yet another idiot anonymous, in which case I'm sorry to the other idiot anonymous who said other idiotic things but not that one), and who said (this one quite clearly) that he's out IN A MONTH if a strategy doesn't work.

I reiterate - you're an idiot.
You may be two idiots, or one idiot, that is an open but entirely non-interesting question.

BTW, that too much money chases fleeting and overfit opportunities is true. I said that in literally my first retort. But keep saying it as it's the only thing you're getting right.