For professional investors only
The momentum factor: the basics and Robeco’s solution
White paper | February 2013
By Willem Jellema, CFA, Portfolio Manager, Joop Huij, PhD, Quantitative Researcher and Simon Lansdorp, PhD, Quantitative Researcher
Willem Jellema, CFA, Portfolio Manager
Joop Huij, PhD, Quantitative Researcher
Simon Lansdorp, PhD, Quantitative Researcher
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– Investors increasingly allocate to factor premiums such as size, value, momentum and low volatility – The momentum effect means that stocks that have performed well in the recent past to continue to perform well – The momentum factor has a relatively high premium and provides attractive diversification benefits because of low correlation with other factors – A conventional momentum strategy takes on high risks and incurs large transaction costs – Robeco Momentum Equities harvests the momentum premium in an efficient way by avoiding unrewarded risks and limiting transaction costs
Introduction Factor investing, which advocates looking beyond traditional asset classifications and allocating to factor premiums such as size, value, momentum and low volatility, is taking ground. Especially since the publication of an influential report for Norges Bank Investment Management,1 one of the largest investment managers in the world, an increasing number of institutional investors allocates to factor premiums, while more are interested. At Robeco, we embrace the concept of factor investing. Since 2006 Robeco manages Conservative Equity strategies to capture the low-volatility premium for equities. At the beginning of 2012, we introduced Robeco Conservative Credits as our low-volatility solution for credit markets. As of August 2012, we also offer Robeco Momentum Equities as our solution to efficiently harvest the momentum factor. We believe there is a strong case for investors to allocate to momentum in their factor portfolios. In this note we will explain why and we will discuss Robeco’s approach to momentum investing. Not only will we explain the momentum effect and its attractive features within a factor portfolio context, we will also
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address the challenges related to momentum investing. We will present the research we have done into ways of dealing with these challenges and how we apply them in our Robeco Momentum Equities fund.
The momentum factor The momentum effect, first documented by Jegadeesh and Titman for the US stock market in 1993,2 is the tendency of stocks to show persistence in performance. The winner stocks, or stocks that performed well in the recent past, on average outperform other stocks in
the subsequent period. Vice versa, loser stocks, or stocks with poor returns, tend to lag behind in the following period as well. The academic literature proposes several explanations for the momentum effect. Some argue that the momentum premium is a compensation for risk.3 Other research identifies behavioral finance as the source of the momentum effect.4 As we will discuss later, we find that not all risks associated with a momentum strategy are rewarded, because they can be avoided without giving up the momentum premium.
The momentum effect around the world
Source: mba.tuck.dartmouth.edu/pages/faculty/ken.french. Large cap momentum portfolio returns from November 1990 to August 2012 (except for the US which starts in January 1927).
Ang, Goetzmann and Schaefer, “Evaluation of Active Management of the Norwegian Government Pension Fund – Global”, Norwegian Ministry of Finance, 2009. Jegadeesh and Titman, “Returns to Buying Winners and Selling Losers: Implications for Stock Market Efficiency”, Journal of Finance, 48, 1993. See, e.g., Chordia and Shivakumar, “Momentum, Business Cycle, and Time-varying Expected Returns”, Journal of Finance, 57, 2002. See, e.g., Gutierrez and Pirinsky, “Momentum, Reversal, and the Trading Behavior of Institutions”, Journal of Financial Markets, 10, 2007.
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The momentum effect is not only present in the US, but in markets all over the world.5 The effect is shown to withstand the test of time and to exist even within the most liquid segment of stocks,6 which is important for a practical implementation of a momentum strategy. The economic significance of the momentum effect for large-cap (as a proxy for liquid) stocks in different regions is illustrated in the figure below. Clearly, the recent winners keep on outperforming the market in each of the different regions, while the losers lag the market.
The momentum factor versus other factor premiums The momentum factor is one of the strongest factors known to exist in equity markets around the world and is used in many balanced ‘quant’ models. Momentum has a high factor premium and as such can be an important source of return for a factor portfolio. This is illustrated
in the figure below on the left, which plots the returns of the market and a number of factors for US equities. Together with value, the momentum factor has the highest return, well above the market. In addition, the momentum premium exhibits a low correlation with lowrisk and value premiums. The figure below on the right shows that momentum is uncorrelated with the size, value and low-volatility factor premiums for US stocks. As a result, the diversification potential of momentum in a factor portfolio is expected to be significant. Because of these two reasons, a momentum fund can be of great benefit to a portfolio that allocates to factor premiums.7
The challenges of momentum investing: unrewarded risk and turnover Despite the attractive features of the momentum factor mentioned above, hardly any investment funds aim to systematically harvest
US factor premiums vs correlations
Source: David Blitz, “Strategic Allocation to Premiums in the Equity Market”, Journal of Index Investing, 2012. Correlations are calculated in excess of the market premium. The sample period is from July 1963 to December 2009.
the momentum premium. As momentum both provides investors an attractive premium in the long run and diversifies strongly with other factor premiums, the question arises why so few funds explicitly target the momentum premium. We believe the answer is that investors face two concerns, or challenges, when they allocate towards momentum: the risk and the turnover of a momentum strategy. A successful momentum strategy needs to be able to deal with these challenges. To explain how a generic momentum strategy, which selects stocks with the highest past returns, can take on large risks and incur high transactions costs, let us have a look at how this strategy works in a bull market. In this upward trending market, the momentum portfolio will mostly contain high-beta stocks, because these stocks earn the highest returns in a bullish environment. This is how momentum earns its premium, because as long as the market continues to rise, the high beta stocks outperform the market. However, when there is a market reversal, the high-beta stocks will be the biggest losers, while low-beta stocks become the new winners. The portfolio incurs large losses on the high-beta stocks, explaining the riskiness of the strategy. Second, the momentum strategy replaces the high-beta stocks with their low-beta counterparts, selling struggling stocks into a down market, which explains the transaction costs. In general, a generic or naïve momentum strategy mostly profits from trends, like the trend in the market described above, and in its wake ends up with stocks geared towards
See, e.g., Rouwenhorst, “International Momentum Strategies”, Journal of Finance, 53, 1998, for evidence on the existence of the momentum effect in European markets, and Rouwenhorst, “Local Return Factors and Turnover in Emerging Stock Markets”, Journal of Finance, 54, 1999, for evidence of the momentum effect in emerging markets. 6 See, e.g., Fama and French, “Dissecting Anomalies”, Journal of Finance, 63, 2008. 7 For more information on factor investing, we refer to our note by David Blitz, Joop Huij, Simon Lansdorp and Pim van Vliet, “Efficient factor-investing strategies”, of February 2013. 5
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these trends. However, when current trends falter and new ones emerge, this can result in significant drawdowns for the strategy, accompanied by a large turnover as the strategy shifts to a new trend. Hence we think the returns from these dynamic exposures to trends, or styles, are elusive, because they result in large risks for the strategy. We believe these risks are unrewarded, because our momentum strategy can earn a similar momentum premium without the accompanying risks.
Research insights: how to deal with the challenges of momentum investing To build a successful momentum fund, the challenges of the large and unrewarded risks and high transaction costs need to be addressed. Over time, Robeco has researched and developed solutions for these issues. First, our research shows that eliminating
dynamic factor exposures results in similar (gross) momentum returns, but at risk levels half that of generic momentum strategies.8 This is achieved by selecting stocks not on their past total returns, but by using their ‘residual’ returns, as explained in the box below. Robeco employs this residualization technique to remove the unrewarded risk of a momentum strategy. Other research by Robeco shows that the use of smart trading rules in investment strategies results in a much lower turnover than the application of naïve trading algorithms, without the loss of gross performance. As a result, net profits increase.9 Robeco achieves this turnover reduction with its proprietary portfolio construction process, which is applied across its whole quant equity product range. We apply both these research findings in Robeco Momentum Equities to capture more of the gross momentum premium at lower risk.
Robeco Momentum Equities: the opportunity to achieve higher net returns at lower risk Momentum is the missing ingredient for many factor investors. Having the research and experience to avoid the pitfalls of momentum investing, Robeco now offers Robeco Momentum Equities. This momentum solution combines the proven insights acquired from and published in academic literature with the dedicated research of Robeco’s Quantitative Research department. A fully committed Quantitative Equity team manages the fund. The figure left shows the added value of Robeco Momentum Equities. It is possible to earn the momentum premium with a generic momentum strategy, but only at a considerable higher risk. Also, the upside is limited, because a large part of the premium is consumed by transaction costs due to high turnover. Robeco’s residualization technique eliminates unrewarded risks, while our proprietary portfolio construction process controls turnover.
Robeco’s residualization technique Residualization means using residual returns instead of total returns. Of the two stocks in the graph opposite, stock B has the highest return. However, the return on B is in line with its expected return given its market sensitivity (beta) of 2, while stock A earns a 5% excess return after correcting for the market. This 5% is the so-called stock-specific or residual return, because it remains after correcting for the market-expected return.
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Because residual momentum selects stocks with the highest stock specific returns, which are by definition unrelated to the stocks’ betas, beta tilts in the resulting portfolio are eliminated. Without this unrewarded risk, the returns of the portfolio are much less sensitive to market and other trend reversals. The result is a similar return pattern as that of a generic momentum strategy, but at much lower risk.
David Blitz, Joop Huij and Martin Martens, “Residual Momentum”, Journal of Empirical Finance, 18, 2011. De Groot, Huij and Zhou, “Another look at trading costs and short-term reversal profits”, Journal of Banking and Finance, 36, 2012
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The result is a momentum fund that, unlike a conventional momentum strategy, preserves most of the gross momentum premium at a considerably better risk profile. Robeco Momentum Equities enables investors to efficiently harvest the momentum premium.
Conclusion Institutional investors are increasingly allocating strategically towards factor premiums. To meet this demand, Robeco introduced Robeco Momentum Equities in August 2012. The momentum factor is attractive from a factor investing point of view as it offers investors a potentially high premium and attractive diversification opportunities. The Robeco approach to momentum investing is designed to capture the momentum premium in an optimal manner by avoiding unrewarded risks and boosting returns by limiting transaction costs.
For more information on factor investing or Robeco active quant solutions please contact your local client relations manager or go to www.robeco.com/quant
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Contact Robeco (Headquarters) P.O. Box 973 3000 AZ Rotterdam The Netherlands www.robeco.com/quant
Important information This document has been carefully prepared by Robeco Institutional Asset Management B.V. (Robeco). It is intended to provide readers with information on Robeco’s specific capabilities, but does not constitute a recommendation to buy or sell certain securities or investment products. All figures are as at the end of the month under review, unless stated otherwise. The information contained in this document is solely intended for professional investors within the meaning of the Dutch Act on the Financial Supervision (Wet financieel toezicht) or persons which are authorized to receive such information under any other applicable laws. The information contained in this publication is not intended for users from other countries, such as US citizens and residents, where the offering of foreign financial services is not permitted, or where Robeco’s services are not available. Investment decisions should only be based on the relevant prospectus and on thorough financial, fiscal and legal advice. The prospectuses are available on request and free of charge from www.robeco.com. The content of this document is based upon sources of information believed to be reliable, but no warranty or declaration, either explicit or implicit, is given as to their accuracy or completeness. This document is not intended for distribution to or use by any person or entity in any jurisdiction or country where such distribution or use would be contrary to local law or regulation. Historical returns are provided for illustrative purposes only and do not necessarily reflect Robeco’s expectations for the future. The value of your investments may fluctuate. Results obtained in the past are no guarantee for the future. All copyrights, patents and other property rights in the information contained in this document are held by Robeco. No rights whatsoever are licensed or assigned or shall otherwise pass to persons accessing this information. Robeco Institutional Asset Management B.V., Rotterdam (Trade Register no. 24123167) is registered with the Netherlands Authority for the Financial Markets in Amsterdam.
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