- Speaker #0
Hello, welcome back to Papers with Factest podcast. Today we dive into another Algo trading research paper. We're tackling a fascinating paper today, Fact Fiction and Momentum Investing by Asnes, Frazzini, Israel, and Moskovitz. Get ready to unpack some common misconceptions about momentum investing. We're talking 200 plus years of data.
- Speaker #1
You know, it's amazing how many myths still surround momentum investing. This paper does a fantastic job at taking those myths head on. Using, you know, rock solid data and analysis.
- Speaker #0
Okay, let's dive right in. But before we bust those myths wide open, can we do a super quick recap of what momentum investing actually is? Just to make sure everyone's on the same page.
- Speaker #1
Absolutely. At its core, momentum investing is the idea that stocks that have done well recently, compared to other stocks, of course, will likely keep outperforming. And on the flip side, the stocks that have lagged behind, well, they tend to keep lagging. It's not just about a stock going up, but how it's performing relative to its peers.
- Speaker #0
Got it. So it's not about blindly chasing the hottest stock of the day. It's more nuanced than that.
- Speaker #1
Exactly. And what's really cool about this paper is that it dives deep into data going back centuries. What they found is that this pattern of momentum isn't just a coincidence. It shows up consistently in all sorts of markets, not just stocks.
- Speaker #0
All right. So let's get to the myth busting. The paper tackles 10 common misconceptions about momentum investing. And I've got to say, some of these were real eye openers for me. Let's start with myth hashtag three. Which claims that momentum only works for small cap stocks.
- Speaker #1
This one is particularly interesting because it turns out that the opposite is actually true for value investing. You might think value investing works best with smaller companies, but the research suggests otherwise. It's actually momentum that works just as well for big companies as it does for small ones.
- Speaker #0
Wait, hold on. Are you saying value investors might actually be missing out, babe, by sticking to small caps?
- Speaker #1
The data seems to suggest that. Israel and Moskowitz, who also debunked a few other momentum myths. found no relationship between a stock's size and how well momentum works. But when it comes to value investing, they found that the premium you get from buying undervalued companies really shrinks when you look at the big players in the market.
- Speaker #0
Wow, that's a huge difference. Yeah. No wonder people are paying attention to momentum. OK, myth hashtag three busted. Let's move on to myth hashtag one. Momentum returns are too small and sporadic to be reliable. Now, this is what I was really curious about. Let's see what the research says.
- Speaker #1
This is a big one. And the data really puts this myth to rest. The authors used Kenneth French's data library, which is like a treasure trove for financial research, to analyze momentum returns. Specifically, they looked at what's called the UMD factor. Think of UMD like a scorecard for how momentum is doing overall in the market. It's the difference between how well the winning stocks are doing versus the losers.
- Speaker #0
OK, so UMD is our momentum measuring stick. What do they find?
- Speaker #1
Well, from 1927 to 2013. The average yearly return for a momentum strategy was a whopping 8.3%. That's way higher than the returns you typically see from strategies focused just on size or value.
- Speaker #0
8.3% annually. Let that sink in for a moment. That definitely doesn't sound small to me. But what about the claim that these returns are sporadic? Does momentum only work occasionally?
- Speaker #1
That's where it gets really interesting. They looked at how often the momentum strategy made money and guess what? Over 80% of the time. Whether you're looking at one-year periods or five-year periods. it delivered positive returns. That's a pretty consistent pattern, wouldn't you say? Yeah,
- Speaker #0
that's not random luck. Myth hashtag one officially busted. Momentum returns are far from small and unreliable. Okay, let's tackle myth hashtag two, which states, momentum can only be exploited on the short side, meaning you have to bet against losing stocks to profit.
- Speaker #1
This is another persistent myth. And again, the evidence completely refutes it. Remember that UMD factor, our momentum scorecard? Well, they dug into both sides of it, the winners and the losers. And guess what? They found that both the winning stocks, A and D, the losing stocks, contributed almost equally to those impressive returns.
- Speaker #0
So it's not just about shorting losers. You can also capitalize on momentum simply by buying winners.
- Speaker #1
Exactly. The idea that momentum is just a short-selling game is just plain wrong.
- Speaker #0
That's a game changer for a lot of investors out there who might not be comfortable with short-selling. Okay, myth hashtag two is down. Let's move on to myth hashtag four, which is a big one for anyone concerned about the... practicalities of trading. This one says, momentum doesn't survive trading costs.
- Speaker #1
Now, this myth comes from the fact that momentum strategies usually involve trading more often than other strategies. But the paper, based on research from 2013 by Frazzini, Israel, and Moskowitz, shows that in the real world, those trading costs are actually pretty low, even for the big institutional investors.
- Speaker #0
Really? But wouldn't more trading automatically mean higher costs? How is that possible?
- Speaker #1
Well... Investors aren't robots. They don't just buy and sell on a whim. They use smarter tactics, like splitting up big orders into smaller chunks and using limit orders to get better prices. This helps to minimize their impact on the market and keep costs down.
- Speaker #0
So it's not about blindly chasing momentum, but incorporating it strategically to keep costs in check.
- Speaker #1
Exactly. And it's kind of like what happened with the size premium. People used to think you couldn't make money from small cap stocks because the trading costs would eat up your profits. But history has shown that with smart execution, even small cap strategies can be profitable.
- Speaker #0
OK, so myth hashtag for busted. Momentum can survive those pesky trading costs. Now let's talk about another practical concern. Myth. Hashtag five, momentum is tax inefficient.
- Speaker #1
This one might seem intuitive because of the higher turnover, right? More trading, more taxes. But here's the surprising truth. Even though you're trading more often, the tax burden for momentum investing is often similar to value investing.
- Speaker #0
Now, that's interesting. I would have thought more trading would automatically mean a bigger tax bill. How does that work?
- Speaker #1
It comes down to the type of trades you're making, not just how many. With momentum, you're typically holding on to winning stocks, which means you're delaying those capital gains taxes. And when you do sell, it's often the losers, which lets you realize losses that can offset other gains. That's a natural tax advantage.
- Speaker #0
So it's not just about the amount trading, but the type of trading that matters for tax efficiency.
- Speaker #1
Exactly. And ironically, value investing, which is known for less frequent trading, can actually be tax inefficient. This is because of those juicy dividends that value stocks often pay out. Those dividends are often taxed at a higher rate.
- Speaker #0
That is surprising. So... Myth hashtag five busted. Momentum, when done right, can actually be quite tax efficient.
- Speaker #1
And the paper goes a step further. The authors actually explored how to optimize momentum strategies to reduce those taxes even more. And unlike with value investing, where you'd have to change your whole approach to avoid dividends, tweaking a momentum strategy for taxes is pretty straightforward.
- Speaker #0
So even for investors who are really sensitive about taxes, momentum is still a solid option. OK, we've already covered a lot, but let's keep going. Myth hashtag six claims that momentum is best used as a screen rather than a direct factor in portfolio construction. What does that even mean?
- Speaker #1
This one gets a bit philosophical. Some people argue that while momentum can be helpful in reading out certain stocks, it shouldn't be a primary factor when you're building your portfolio. They think you should use it like a filter after you've already chosen your stocks based on other factors like value.
- Speaker #0
So it's like a secondary tool, not the main event.
- Speaker #1
Yeah. But here's the catch. If you're already using momentum to filter stocks, you're basically admitting that it works, right? It's like saying momentum might have some power, but I'm not going to give it full credit.
- Speaker #0
It seems to be contradictory, doesn't it?
- Speaker #1
It definitely is. And honestly, the only reason to use momentum as a screen would be if those other myths were true. Like if it only worked with small caps or if trading costs were a huge problem. But we already busted those myths. So using momentum directly alongside something like value makes way more sense.
- Speaker #0
Got it. So myth. Hashtag six busted. Momentum deserves to be a star player, not just a benchwarmer. All right. Moving on to myth hashtag seven, which I hear a lot when people talk about any investment strategy. It claims one should be particularly worried about momentum's returns disappearing in the future.
- Speaker #1
This is a valid concern for any factor, not just momentum. But it seems like people bring it up more often with momentum, maybe because it's a newer area of research or because they focus on the behavioral explanations.
- Speaker #0
So is the worry justified? Is there any reason to believe momentum is more likely to fade away than other factors like size or value?
- Speaker #1
Not really. Both the risk-based and the behavioral explanations for momentum suggest that it's here to stay. Plus, we have over 200 years of data backing it up. It's a pretty strong track record.
- Speaker #0
But couldn't any factor, even one with a long history, potentially disappear in the future? I mean, markets are always changing.
- Speaker #1
Absolutely. Future returns are never a guarantee, no matter what strategy you're using. But the question is... Is there a specific reason to single out momentum and worry about it disappearing? And based on what we know, the answer is no.
- Speaker #0
So myth hashtag seven is more of a general investing worry than a momentum specific problem.
- Speaker #1
Exactly. And research has actually shown that momentum hasn't weakened, even after it became widely known and embraced by big institutional investors. In fact, Israel and Moskowitz found no evidence. that momentum returns were shrinking, even as trading costs went down and more people jumped on the bandwagon.
- Speaker #0
That's reassuring. OK, let's tackle myth hashtag eight, which pops up a lot when discussing strategies that can have some wild swings. Momentum is too volatile to rely on.
- Speaker #1
Right. And this myth comes from the fact that momentum can have some rough patches. Like what happened in the spring of 2009?
- Speaker #0
Yeah, that wasn't a fun time for anyone betting on momentum.
- Speaker #1
It wasn't. However, it's important to remember that every investment strategy has its down periods. Remember. Value in investing took a hit in the late 1990s, and even people who simply invested in the entire market had a rough time in 2008.
- Speaker #0
So experiencing occasional downturns is just part of the game, no matter what you're investing in.
- Speaker #1
Exactly. And what's interesting is that even with those occasional dips, momentum still has a higher sharp ratio than size or value. That means you're getting more return for the risk you're taking.
- Speaker #0
But even though those drops don't erase the long term gains, they can still be pretty scary, right? Is there a way to smooth things out and make those risks more manageable?
- Speaker #1
Absolutely. And that's where the magic of combining momentum with value comes in. This combo has historically led to much smoother returns, basically eliminating those worst-case crashes that either strategy would experience on its own.
- Speaker #0
So it's not about avoiding momentum because of its volatility. It's about using it strategically, alongside other strategies, to create a more balanced portfolio.
- Speaker #1
Precisely. Now let's talk about myth hashtag 9, which seems more like a technical detail than a real myth. This one says, different measures of momentum can give you different results over a given period. That's true. But it's important to remember that this isn't a flaw specific to momentum. You see the same thing with any factor. Let's take value investing as an example. You can measure value using different metrics, like price to earnings, price to book, or price to cash flow. Each of those might give you slightly different results over a short period, but the overall value effect is still there over the long term.
- Speaker #0
So it's not about finding the one perfect way to measure momentum. It's about understanding that there are multiple valid approaches. but they all capture the same underlying idea.
- Speaker #1
Exactly. And research has even shown that using simple measures or combining multiple measures can actually lead to better results for momentum strategies.
- Speaker #0
Okay, so myth hashtag 9 is more about acknowledging the nuances of measurement, rather than a reason to dismiss momentum altogether.
- Speaker #1
Absolutely. Now onto the final myth. Myth hashtag 10. There's no theory behind momentum. This one gets to the core of whether momentum is just a random pattern or something more substantial. This myth needs to be busted decisively. While there might not be one universally accepted theory, momentum is far from lacking a theoretical foundation.
- Speaker #0
So what are the main explanations for why momentum exists?
- Speaker #1
There are two main categories of explanations, risk-based and behavioral. Risk-based theories suggest that momentum is basically a reward for taking on certain economic risks. Behavioral theories, on the other hand, Say it's all about investor biases, like being slow to react to new information or following the herd.
- Speaker #0
So it's like the age old nature versus nurture debate, but for financial markets.
- Speaker #1
Exactly. But the key takeaway here is that both types of explanations suggest that momentum should continue to exist.
- Speaker #0
And that mountain of historical data from all sorts of different markets needs to agree.
- Speaker #1
Absolutely. And it's worth pointing out that this lack of a single definitive theory isn't unique to momentum. We see the same kind of debates about the underlying causes of the size and value premiums, too.
- Speaker #0
So. Myth hashtag 10 busted. Momentum is more than just a fluke. It's supported by both risk-based and behavioral explanations, which means it's likely here to stay. Okay, we've thoroughly debunked all 10 myths surrounding momentum investing. That was awesome.
- Speaker #1
And remember, this paper doesn't just tear down misconceptions. It also gives us a solid framework for understanding how momentum works and how to use it in our investment strategies.
- Speaker #0
Exactly. It's a reminder that we need to look beyond the headlines. And dig into the data if we want to make informed investment decisions.
- Speaker #1
Absolutely. And while momentum, like any factor, can have periods where it underperforms, its long-term track record and the evidence presented in this paper make it a factor worth serious consideration.
- Speaker #0
I totally agree. Now, let's shift gears a bit and get into the nitty-gritty of the trading rules and backtesting results presented in the paper.
- Speaker #1
Sounds good. One of the things the authors really emphasize is how they built that momentum factor we talked about earlier, the UMD factor. They used Kenneth French's data library, which, as we mentioned, is a goldmine of historical financial data. So how do they actually define and calculate UMD?
- Speaker #0
Yeah, let's break that down.
- Speaker #1
They started with all the stocks listed on major U.S. exchanges like the NYSE, Amex and Nasdaq-U. Then for each stock, they calculated its return over the past 12 months, but they skipped the most recent month. To avoid any short term noise or weird price jumps, that might distort the results.
- Speaker #0
That makes sense. They're looking for sustained momentum, not just a quick blip in the stock price.
- Speaker #1
Exactly. Then they ranked all those stocks based on their 12-month returns and divided them into three groups. The top 30% are the winners. That's the up part of UMD. The bottom 30% are the losers. That's the down part. And they basically ignored the middle 40%.
- Speaker #0
They're focusing on the extremes. The stocks that have shown the strongest and weakest performance.
- Speaker #1
Precisely. And to get the UMD factor, they simply took the average return of the winners and subtracted the average return of the losers. Simple. Right.
- Speaker #0
Simple and elegant. So what did the backtesting results over this long period tell us about how effective this UMD strategy actually is?
- Speaker #1
The results are pretty compelling. Over that entire period from 1927 to 2013, UMD delivered an average annualized return of 8.3%. And remember, that's significantly higher than the returns for just focusing on size, SMB, or value HML.
- Speaker #0
That aligns with what we talked about earlier, how momentum has historically outperformed other strategies. But was that just a lucky streak for the entire period? Did the strategy work consistently across different time periods?
- Speaker #1
That's a great question. The authors address this by breaking down the data into smaller periods, for example, from 1963 to 2013, which is the period a lot of people associate with the rise of factor investing. Thanks to Fama and French's research, the UMD strategy actually delivered an even higher average annual return of 8.4%.
- Speaker #0
So even during a time when size and value were doing well, momentum held its own.
- Speaker #1
Yes. And even more importantly, they tested the strategy and the period after momentum became an established concept in academic research. That period starts around 1991.
- Speaker #0
That makes sense. If a strategy only works before people know about it, that would raise some red flags, right?
- Speaker #1
Exactly. Testing a strategy on data from a period after it's been discovered is crucial. What they found was that even from 1991 to 2013, the UMD strategy generated an average annualized return of 6.3%.
- Speaker #0
So the returns were a bit lower in that later period, but still pretty substantial.
- Speaker #1
Absolutely. These results suggest that momentum isn't just some historical fluke. It's a phenomenon that has continued to work, even after becoming widely known and studied.
- Speaker #0
That's incredibly encouraging for anyone thinking about incorporating momentum into their trading strategy.
- Speaker #1
It is. But remember, no investment strategy is without risk. And that's something the authors explore in detail, too.
- Speaker #0
That's right. There's no such thing as a free lunch in the markets. So let's talk about the risks associated with momentum investing. What did the research highlight?
- Speaker #1
One of the biggest risks they talk about is the potential for momentum crashes. Remember when we were debunking the myth about momentum being too volatile?
- Speaker #0
Yeah. Those sudden drops can be scary, even if they don't erase the long-term gains.
- Speaker #1
Exactly. And while these crashes are relatively rare, they can be pretty sharp and painful for investors.
- Speaker #0
So what causes those crashes? Are they just random events or is there a pattern?
- Speaker #1
The authors found that these crashes tend to happen after a long bear market. followed by a sudden upswing in the market.
- Speaker #0
So it's like a sudden reversal of fortune. That catches momentum investors off guard.
- Speaker #1
Exactly. What happens is that during a bear market, when prices are generally going down, momentum strategies tend to hold stocks that haven't fallen as much. These are called low beta stocks. They also short stocks that have dropped a lot, the high beta stocks. That makes sense. But then when the market suddenly rebounds, those high beta stocks tend to shoot up much faster than the low beta stocks. This sudden shift can really hurt momentum portfolios, especially if they're shorting those high beta stocks.
- Speaker #0
So it's the short side of the momentum strategy that's most vulnerable during these crashes.
- Speaker #1
That's what the research seems to suggest.
- Speaker #0
Which aligns with what we discussed earlier about the long side of momentum being just as profitable as the short side.
- Speaker #1
Exactly. And this finding highlights the potential benefits of focusing on the long side of momentum, especially for investors who aren't comfortable with short selling.
- Speaker #0
So while momentum can have these occasional crashes, there are ways to minimize that risk. You could focus on buying winners instead of shorting losers. And you can combine momentum with other strategies like value investing.
- Speaker #1
Precisely.
- Speaker #0
Okay. We've covered a ton of ground on the theory, the trading rules, and the risks of momentum investing.
- Speaker #1
And we've seen that even though there are a lot of myths surrounding momentum, it has consistently delivered strong returns over the long run.
- Speaker #0
Absolutely. But as we wrap up this first part of our deep dive, I want to come back to something we talked about earlier, the idea that even if Momentum's returns completely disappeared, it could still be a valuable tool for investors.
- Speaker #1
That's a great point. It highlights a crucial aspect of building a strong portfolio, diversification.
- Speaker #0
Right. It's not just about chasing the highest possible returns. It's also about managing risk effectively.
- Speaker #1
Exactly. And even if Momentum stopped providing those extra returns, it's low correlation with other factors. factors, especially value, makes it a powerful tool for diversification.
- Speaker #0
So even in a hypothetical world where momentum no longer beats the market, its ability to reduce portfolio volatility would still make it worthwhile.
- Speaker #1
Exactly.
- Speaker #0
OK, I think we've covered a lot in this first part of our deep dive.
- Speaker #1
We sure have. We've explored the history of momentum investing, busted those common myths and dug into the trading rules and risks associated with this strategy.
- Speaker #0
We've also seen how momentum Even though it can be a bit volatile at times, it can be a powerful tool for investors, both on its own and, perhaps even more importantly, as a complement to other strategies like value investing. But that's a discussion for our next segment.
- Speaker #1
You know what's really fascinating about this paper is that it doesn't just present momentum as a one-size-fits-all concept. It actually explores ways to tweak and refine the basic momentum strategy to create different variations.
- Speaker #0
That's a great point. Even though the core idea of momentum is pretty straightforward, there's always room for improvement and adapting it to different market conditions or investor preferences.
- Speaker #1
Exactly. And one of the interesting variations the authors discuss is something called industry momentum. Oh,
- Speaker #0
that sounds intriguing. So instead of just looking at the momentum of individual stocks, we're talking about the momentum. entire industries.
- Speaker #1
Precisely. The idea is that just like individual stocks, entire industries can go through periods of outperformance or underperformance and those trends can create momentum opportunities.
- Speaker #0
That makes sense. It's like zooming out and applying the momentum concept on a larger scale. So how does this industry momentum work in practice? Do they just rank industries based on their recent returns and then buy the top performers?
- Speaker #1
It's similar to the way we measure stock momentum, but instead of individual companies We're looking at groups of companies within the same industry. They calculate the past returns for each industry, usually over a 12-month period, and then rank them from highest to lowest.
- Speaker #0
Okay. So it's about identifying those industries that are showing consistent strength compared to others.
- Speaker #1
Exactly. And the research suggests that adding this layer of industry momentum can actually improve a momentum strategy.
- Speaker #0
Really? What's the advantage of incorporating industry momentum?
- Speaker #1
One of the big benefits. is that industry momentum tends to be less volatile than individual stock momentum.
- Speaker #0
That's interesting. Why would that be?
- Speaker #1
Think about it this way. Individual stocks can be affected by all sorts of things, like company-specific news, earning surprises, or even just random market noise. But industries, since they're made up of multiple companies, are less sensitive to those random ups and downs. It's like averaging out the noise to get a clearer signal of momentum.
- Speaker #0
It's like smoothing out the ride a bit, making it less bumpy for investors. who are a bit more risk averse.
- Speaker #1
Exactly. And this reduced volatility can make industry momentum more appealing to investors who are looking for a smoother investment experience.
- Speaker #0
That makes a lot of sense. But does playing it safer with industry momentum means sacrificing some of those potential returns?
- Speaker #1
Not necessarily. The research has actually shown that you can potentially boost your returns while also lowering volatility by adding industry momentum to your strategy.
- Speaker #0
Wow. That sounds like a win-win.
- Speaker #1
It kind of is. And that's why industry momentum can be such a compelling addition to a momentum strategy. It's especially helpful for those who are really focused on managing risk effectively.
- Speaker #0
So it's like adding another layer of diversification, not just across different stocks, but also across different sectors of the economy.
- Speaker #1
Exactly. Now, on top of industry momentum, the authors also explore another interesting twist on the classic momentum strategy, long-term momentum.
- Speaker #0
Oh, this sounds intriguing. So instead of just looking back over the past 12 months, we're extending that time horizon.
- Speaker #1
That's right. With long-term momentum, we're typically looking at returns over a longer period, like three to five years.
- Speaker #0
Interesting. So is the idea here that momentum can actually persist for much longer periods than we might initially think?
- Speaker #1
Exactly. And there's a growing body of research that suggests long-term momentum might be even more powerful than the short-term kind.
- Speaker #0
Really? That's surprising. Wouldn't you expect... those trends to eventually fade away over time? It seems like the longer a trend goes on, the more likely it is to reverse.
- Speaker #1
That's what you might think. But the research suggests otherwise. There are a couple of possible explanations for why this long-term momentum might actually stick around. Okay,
- Speaker #0
I'm all ears.
- Speaker #1
One possibility is that it simply takes the market longer to fully digest new information, and for that information to be reflected in stock prices. Think about companies going through big changes, like launching a brand new product or shifting their entire business model. It could take years for the market to fully grasp the implications of those changes.
- Speaker #0
So it's like the market is a bit slow on the uptake when it comes to these long-term trends, which allows those with a longer-term perspective to potentially capitalize on those inefficiencies.
- Speaker #1
Exactly. Another possibility is that long-term momentum is driven by behavioral factors, like investors piling into stocks that have already been doing well, a sort of herd mentality. Or maybe it's that people tend to stick with their winners for far too long, even when the fundamentals might suggest otherwise.
- Speaker #0
So it's like the psychology of winning can create its own momentum that keeps pushing those stocks higher for longer than we might rationally expect.
- Speaker #1
Precisely.
- Speaker #0
So what does the research say about how effective long-term momentum is? Compared to the more traditional 12-month momentum, does holding on for longer really pay off?
- Speaker #1
The findings are pretty compelling. Studies have shown that portfolios built using long-term momentum tend to have higher returns, A&D lower volatility, compared to portfolios built using that shorter-term momentum signal.
- Speaker #0
Wow. So you get more return with less risk. That sounds fantastic.
- Speaker #1
It does. And these results have led some researchers to believe that long-term momentum might actually be a more attractive investment factor. than the more common short-term momentum.
- Speaker #0
But wouldn't using a longer-term signal also mean you're trading less often?
- Speaker #1
That's right, because you're holding those stocks for longer periods. You're not buying and selling as frequently. This can really help reduce those pesky trading costs and could even make your strategy more tax efficient.
- Speaker #0
This is like a triple win. Potentially higher returns, less volatility, and lower costs.
- Speaker #1
Exactly. Long-term momentum is a very appealing option for investors. who are looking for a more patient and tax-efficient way to approach momentum investing.
- Speaker #0
This paper does a great job showing how the momentum factor can be tweaked and modified to create all sorts of different trading strategies. It's not a one-size-fits-all approach. There's something for everyone, depending on their investment style and risk tolerance.
- Speaker #1
Absolutely. And it emphasizes the importance of really understanding the nuances of momentum, not just blindly following past winners.
- Speaker #0
Right. It's not about chasing the latest hot stock. It's about understanding the different ways momentum can play out in the market and how to use it strategically to build a robust and well-divided portfolio.
- Speaker #1
Exactly. And speaking of combining momentum with other factors, one of the biggest takeaways from this paper is the power of combining momentum with value.
- Speaker #0
We've talked about that a bit already, but I think it's worth emphasizing. The authors really make a compelling case for why these two factors work so well together.
- Speaker #1
They really do. And it's not just about the fact that they've both been successful in the past. It's about how they complement each other from a risk management perspective.
- Speaker #0
Right. Because as we discussed, both momentum and value can have periods of underperformance. And those periods can be pretty rough sometimes.
- Speaker #1
Exactly. And the beauty of combining them is that those down cycles tend to happen at different times.
- Speaker #0
So it's like having a built-in safety net within your portfolio. When one factor is struggling, the other one is there to soften the blow.
- Speaker #1
Precisely. And the research shows that a portfolio that combines momentum and value tends to be much less volatile and experiences smaller drawdowns compared to portfolios that focus on just one of those factors.
- Speaker #0
That's really convincing evidence. It really underscores why diversification is so important. And we're not just talking about spreading your money across different stocks. It's about diversifying across different investment factors, too.
- Speaker #1
Absolutely. And the authors argue that combining momentum and value isn't just about reducing risk. It can actually help you increase returns, too.
- Speaker #0
Really? How so?
- Speaker #1
Well, let's break it down. Value investing, at its heart, is a contrarian strategy. You're buying stocks that have fallen out of favor and that the market considers undervalued.
- Speaker #0
Right. The classic buy low, sell high approach.
- Speaker #1
Exactly. Momentum, on the other hand, is a trend-following strategy. You're buying stocks that have been going up. And are considered to have strong momentum.
- Speaker #0
So they're almost opposites in a way.
- Speaker #1
In a sense, yes. But by combining them, you're essentially taking advantage of two different forces that can drive stock prices.
- Speaker #0
Interesting. So you're basically creating a portfolio that can profit, both from finding those hidden gems that the market has overlooked and from riding those powerful upward trends.
- Speaker #1
Precisely. And the authors believe that this combination can lead to a more consistent and robust portfolio, one that's less likely to be thrown off. course by sudden market shifts.
- Speaker #0
So this paper doesn't just debunk myths about momentum investing. It also builds a strong case for why momentum deserves to be a key part of any well-diversified portfolio, especially when combined with value.
- Speaker #1
I completely agree. And it really encourages investors to move beyond those simple buy and hold strategies and embrace a more dynamic and strategic approach to investing.
- Speaker #0
That's a great takeaway. Now, as we wrap up this part of our discussion, I think it's time to shift gears a bit. And talk about what all this means for algo traders. After all, this algo is a podcast about using academic research to build real-world trading strategies.
- Speaker #1
Great idea. Let's explore how algo traders can translate these insights into actionable strategies. Perfect.
- Speaker #0
So, Based on what we've learned about momentum investing, what are some key things algo traders need to keep in mind when trying to put these ideas into practice?
- Speaker #1
Well, one of the first things to figure out is how to define and measure momentum in a way that works well for an algorithm. Remember, we talked earlier about how there are different ways to measure momentum from simply looking at past returns to using more complex indicators that factor in things like volatility or trading volume.
- Speaker #0
Right. Because you can't just tell a computer, hey, find me stocks with momentum. You have to give it specific instructions on how to measure that.
- Speaker #1
Exactly. And for algo traders, it's crucial to choose a momentum metric that's easy to calculate and can be seamlessly integrated into their trading algorithms.
- Speaker #0
So simplicity and efficiency are key considerations here.
- Speaker #1
Absolutely. And just as important is the quality and availability of the data they're using.
- Speaker #0
Right. Because if you feed bad data into your algorithm, you're going to get bad results out.
- Speaker #1
Exactly. Algo traders need access to accurate historical data so they can test their momentum strategies and make sure they're robust. They can't just rely on hunches or gut feelings. They need solid evidence.
- Speaker #0
And this data needs to be detailed enough to capture all the nuances of momentum at different time scales.
- Speaker #1
You got it. Once they have a solid way to measure momentum and a good source of data, they can start exploring different ways to implement their strategies.
- Speaker #0
So what are some of the go-to approaches for implementing momentum in algorithmic trading?
- Speaker #1
One very popular approach is called trend following. In this approach, algorithms are designed to identify and capitalize on existing trends in stock prices.
- Speaker #0
So, it's like having an algorithm that automatically buys stocks that are breaking out to new highs, and sells stocks that are breaking down to new lows.
- Speaker #1
That's the basic idea, of course. These algorithms can get quite sophisticated, with various filters and risk management rules to optimize performance.
- Speaker #0
That makes sense. What are some other common approaches?
- Speaker #1
Another widely used approach is mean reversion. This strategy is based on the idea that prices tend to revert to their average over time.
- Speaker #0
So it's like betting on the idea that what goes up must come down and vice versa.
- Speaker #1
You could say that. Mean reversion strategies usually involve buying stocks that have dipped significantly below their average price and selling those that have risen far above their average.
- Speaker #0
Interesting. So where does momentum fit into these mean reversion strategies?
- Speaker #1
Momentum can actually be used as a filter. To help identify stocks that are likely to revert, for example, an algo trader might look for stocks that have taken a sharp dive, but still show positive momentum over a longer period.
- Speaker #0
So it's like using momentum to pinpoint those oversold stocks that still have the potential to bounce back.
- Speaker #1
Exactly. Combining mean reversion with momentum can be a powerful tool for algo traders.
- Speaker #0
So there are many ways to incorporate momentum into algorithmic trading, whether it's through trend following, mean reversion or other approaches.
- Speaker #1
Absolutely. And the key is to choose an approach that aligns with the algo traders individual investment style and risk tolerance.
- Speaker #0
Right. There's no one size fits all solution in the world of algorithmic trading. Everyone has their own preferences and comfort levels.
- Speaker #1
Exactly. And speaking of tailoring strategies, another crucial thing for algo traders is backtesting.
- Speaker #0
We touched on this earlier, but I think it's worth emphasizing again. Backtesting is absolutely essential for any algo trading strategy. Especially when it's based on momentum.
- Speaker #1
Absolutely. And the paper we're discussing today provides some excellent insights into how to backtest momentum strategies effectively.
- Speaker #0
So what are some key takeaways from the paper when it comes to backtesting momentum strategies?
- Speaker #1
One of the most important things they stress is using a long enough data history.
- Speaker #0
That makes sense. Momentum plays out over time, so you need enough historical data to capture those patterns accurately.
- Speaker #1
Exactly. They recommend using at least several decades of data. if possible, that way. Your backtesting results are more likely to be reliable and statistically significant. You don't want to base your decisions on flimsy evidence.
- Speaker #0
Makes sense. What other factors should algo traders consider when they're backtesting momentum strategies?
- Speaker #1
Another crucial thing to consider is transaction costs. As we talked about before, momentum strategies can involve trading more frequently and those costs can add up quickly.
- Speaker #0
Right. Those costs can eat into your profits if you're not careful.
- Speaker #1
Exactly. So when you're backtesting, It's crucial to factor in realistic transaction costs to get an accurate picture of the strategy's true profitability.
- Speaker #0
And those costs can vary depending on how often you're trading, the size of your trades, and how easy it is to buy or sell the stock to your target.
- Speaker #1
Exactly. And here's another thing to keep in mind. Slippage.
- Speaker #0
Slippage. I'm not familiar with that term.
- Speaker #1
Slippage is the difference between the price you expect to get when you place a trade and the actual price you end up getting when the trade is executed.
- Speaker #0
Ah, so it's like the price slipping away from you while you're trying to catch it.
- Speaker #1
You could say that. And slippage can be a big deal for momentum strategies. Because they often involve trading stocks that are moving quickly.
- Speaker #0
So if a stock is shooting higher and you're trying to buy in, you might end up paying a higher price than you expected because of slippage.
- Speaker #1
Exactly. And that can eat into your profits. So it's really important to factor in slippage when you're backtesting momentum strategies.
- Speaker #0
So backtesting is a lot more than just plugging in some numbers and seeing what pops out. It's about creating a realistic simulation. That accounts for all the real-world factors that can impact a momentum strategy's performance.
- Speaker #1
Precisely. And the authors of this paper provide some really valuable guidance on how to do that effectively.
- Speaker #0
Fantastic. I think we've covered a lot of ground in this part of our deep dive.
- Speaker #1
We sure have. We explored some interesting variations on the basic momentum strategy, like industry momentum and long-term momentum, and talked about how algo traders can put these ideas to work.
- Speaker #0
We also stressed the importance of backtesting and highlighted key things to remember. to make sure those backtests are as realistic and reliable as possible.
- Speaker #1
Yes, absolutely. And as we move into the final part of our deep dive, I'm really looking forward to discussing some of the broader implications of this research and exploring some potential areas for future investigation. It's not just about the how-to. It's about understanding the bigger picture of momentum investing.
- Speaker #0
Me too. I'm ready to get philosophical and explore the deeper meaning of all this. Welcome back to the final part of our deep dive into momentum investing. We've We've busted those persistent myths, explored the trading rules, and even delved into the nitty gritty of bag testing.
- Speaker #1
Now let's zoom out a bit and consider some of the bigger questions this research raises. OK,
- Speaker #0
I'm ready to get philosophical. What are some of the broader implications of all this research on momentum investing? What does it tell us about the markets and how they work?
- Speaker #1
One of the most intriguing questions it brings up is what does the persistence of momentum tell us about market efficiency? Ah,
- Speaker #0
yes, the classic debate. Are markets truly efficient, where prices reflect all available information, or are there inefficiencies that savvy investors can exploit?
- Speaker #1
Exactly. The traditional efficient market hypothesis says that prices already factor in everything that's publicly known, making it impossible to consistently beat the market.
- Speaker #0
So, in a perfectly efficient market, any mispricings would be quickly noticed and corrected by smart investors, right?
- Speaker #1
Precisely. But the fact that momentum exists and continues to work even after being widely studied and adopted, challenges that idea. It seems to defy that efficient market logic.
- Speaker #0
Does momentum success mean that markets are actually inefficient?
- Speaker #1
Well, it's not that simple. Even the biggest believers in efficient markets admit that there are different levels of efficiency.
- Speaker #0
Right. There's that idea of weak-form efficiency, which means that past prices can't predict future prices. Then there's semi-strong-form efficiency, which says that all publicly available information is already baked into prices. And then there's strong form efficiency, which implies that even private information can't give you an edge.
- Speaker #1
Exactly. And momentum success seems to challenge that weak form efficiency because it relies on the idea that past returns can, in fact, give us clues about future returns. But that doesn't necessarily mean markets are totally inefficient. It doesn't contradict those stronger forms of efficiency.
- Speaker #0
So it's possible that momentum arises from things like behavioral biases or other factors that don't necessarily mean the market is bad at processing information.
- Speaker #1
Precisely. And that's where things get really interesting. Some people argue that momentum success is proof that investors aren't always rational. Others say it can be explained by perfectly rational risk based models. It's a fascinating debate.
- Speaker #0
It's like that nature versus nurture debate. But for financial markets, are we seeing innate market inefficiencies or is it investor behavior? that's creating these opportunities.
- Speaker #1
Exactly. And this debate is far from settled. But no matter what the underlying explanation is, the fact that momentum has worked for over two centuries suggests that it's not something we should ignore.
- Speaker #0
Absolutely. And for algo traders, this persistence is really encouraging. It suggests that there might be ways to systematically capture these momentum profits using sophisticated algorithms.
- Speaker #1
Exactly. And as we discussed earlier, there are many different approaches to incorporating momentum into algo trading strategies, whether it's trend following, mean reversion or other techniques.
- Speaker #0
Right. The key is to rigorously test those strategies and make sure they hold up in the real world with all its complexities.
- Speaker #1
Couldn't agree more. And another important thing this research highlights is the need to be adaptable.
- Speaker #0
Adaptable. What do you mean by that? Well,
- Speaker #1
markets are constantly changing and what worked yesterday might not work tomorrow.
- Speaker #0
Right. That's why they say past performance is not indicative of future results.
- Speaker #1
Exactly. And this is especially true for momentum investing, because it's all about finding and exploiting trends. And trends, by their very nature, can shift and change.
- Speaker #0
So algo traders need to be on their toes, constantly monitoring their momentum strategies to make sure they're still effective.
- Speaker #1
Absolutely. They might need to tweak their algorithms, adjust their parameters. or even develop entirely new strategies as the market landscape evolves.
- Speaker #0
So it's not just about setting up an algorithm and letting it run on autopilot. It's about ongoing. Monitoring, adaptation, and innovation.
- Speaker #1
Exactly. And that's why it's so crucial for algo traders to stay up to date with the latest research and developments in the field. They need to be constantly learning and evolving their strategies to stay ahead of the curve.
- Speaker #0
And that's where resources like podcasts, academic journals, and industry conferences come in handy.
- Speaker #1
Absolutely. It's all about bridging the gap between the academic research and what's actually happening in the markets.
- Speaker #0
Well, on that note, I think we've reached the end of our deep dive into momentum investing.
- Speaker #1
It's been a fantastic journey exploring the history, debunking the myths, dissecting the trading rules, and pondering the broader implications of this powerful investment factor.
- Speaker #0
We've learned that momentum, while not without its risks, can be a valuable tool for investors and algo traders alike.
- Speaker #1
Absolutely. And as always, the key is to approach it with a clear understanding of how it works, its potential pitfalls, and the importance of diversification and ongoing adaptation.
- Speaker #0
Couldn't have said it better myself. Thank you for tuning in to Papers with Backtests podcast. We hope today's episode gave you useful insights. Join us next time as we break down more research. And for more papers and backtests, find us at https.paperswithbacktests.com. Happy trading!
