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How Momentum Traders Can Avoid Vicious Drawdowns

 November 27, 2012 04:34 PM

(By David Brickell) Over recent months we've been considering the fact that trading momentum - buying winners and selling losers - works extremely well. In fact, the returns from the strategy are much higher than those from value or growth strategies, albeit at the cost of greater volatility. We've seen that momentum strategies can 'crash', as was witnessed in 2002/3 and 2009, and many hedge funds as a result have given up on it as a trading strategy.

However a groundbreaking research paper by David Blitz, Joop Huij and Martin Martens published in the Journal of Empirical Finance in January 2011 introduced a novel way of investing in momentum that appears to hold some hope for those investors that can't help but chase winning stocks. In it they promoted the idea that stripping the market's influence out of each stock's measured return can seriously improve the profits from a momentum strategy.

[Related -Bogle Says Indexing Destined To Win The Battle Of The Quants]

To illustrate these ideas, it may help if one thinks of the stock market as a sea of fish. Historically these fish have all been very independent minded and while they've always been affected by ocean currents, they have swum very independently. But since the turn of the millennium the fish have begun to behave more and more like a shoal, more and more like synchronised swimmers, ebbing and flowing in unison.

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Before 2000, the average stock's daily move was perhaps 20% correlated with the overall market, but this correlation has risen year after year to reach 50% by the beginning of the year (see image below). Given the growing influence of ETF and index funds and the dominance of macro-politics on market swings, this is perhaps unsurprising, but it's making it a much harder market for traditional stock pickers to outperform in.

Andrew Lapthorne, global head of quant research at Societe Generale, states that when "macro and market events and not company fundamentals drive stock prices then using momentum as a trading signal becomes fraught with danger".

The solution, as described by Blitz, Huji and Martens, is to focus on the momentum of the stock not explained by the impact of the overall stock market. By stripping out the market sensitivity from each stock's share price returns they can then be ranked by what they call the stock's "residual momentum".

Soc Gen, when testing this strategy, confirm that globally annualised returns are on average of the order of 11% per year since 1989 - outperforming standard momentum in every region and even in Japan. When married with a value strategy, the results are even more impressive - with risk adjusted returns 80% higher using this methodology. Blitz et al show that the annual volatility of momentum as a strategy can be reduced from 22.7% to only 12.5%.

So the returns to "residual" momentum strategies are comparable to or better than standard momentum but at only half the risk. Blitz et al also discover that they are more consistent over time, more consistent over the business cycle, and less concentrated in small caps. Not only that, but they find that the strategy even works over longer holding periods of more than a year. The question that remains is, why aren't more people following it?

The answer is that it's not exactly the easiest thing to calculate. While everyone can understand a stock's total return, or even it's relative strength, to figure out the return to the share price not explained by the market requires running a more advanced mathematical process known as a linear regression and the use of a 'three factor' model loaded with academic numbers.

Clearly, this is the kind of work that is preferentially done by hedge funds and quantitative trading desks in the city - who scalp profits from the big, old fashioned mutual funds that the majority of investors put their hard earned savings into. One of our goals at Stockopedia is to bring the benefits of this kind of quantitative analysis to the public domain. While we aren't yet publishing each stock's "residual momentum" on the website, we are becoming increasingly convinced that it may be the best way to rank momentum stocks and are considering incorporating it into our growing library of outperforming momentum strategies. In the meantime, have a look at the returns to a traditional price momentum screen in the strategy centre - gaining +25% year to date with some impressive household names in the list!



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