Description

Have you ever wondered how momentum and contrarian strategies can be leveraged to achieve abnormal returns in the world of ETFs? In this enlightening episode of the Papers With Backtest: An Algorithmic Trading Journey podcast, our hosts dive deep into the intricacies of a groundbreaking research paper that explores the dynamics of abnormal returns through momentum and contrarian strategies using Exchange-Traded Funds (ETFs). With ETFs now accounting for a staggering 35% of U.S. wealth in passively managed investments, understanding these strategies has never been more crucial for traders and investors alike.

The episode begins with a thorough examination of classic momentum strategies, which involve buying ETFs that have shown strong performance while simultaneously shorting those that have lagged behind. Our hosts dissect the compelling data that reveals momentum strategies can yield statistically significant returns, particularly when portfolios are held for periods ranging from 4 to 39 weeks. Notably, a 20-week holding period stands out, delivering an impressive 13.5% annualized return—a figure that underscores the potential of momentum trading in today’s market.

But what about contrarian strategies? The hosts introduce this intriguing approach, which focuses on betting against high performers and investing in underperformers. The research indicates that contrarian strategies shine over significantly shorter time frames, with a remarkable 86.9% annualized return for one-day holds. This contrast between momentum and contrarian tactics raises essential questions about investment timing and strategy selection.

Throughout the episode, the discussion also highlights the critical role of transaction costs and their impact on overall profitability. The paper suggests a surprising finding: not rebalancing portfolios could lead to better results, challenging conventional wisdom about portfolio management. As the hosts navigate through these insights, they emphasize the importance of understanding the varying performance of different ETF categories and how market conditions can significantly influence the effectiveness of each strategy.

Join us as we unravel the complex world of algorithmic trading and the powerful insights derived from the research paper on abnormal returns with momentum contrarian strategies. Whether you’re a seasoned trader or just starting your journey in the world of ETFs, this episode of Papers With Backtest: An Algorithmic Trading Journey will equip you with the knowledge and understanding needed to navigate this dynamic landscape. Tune in for an episode filled with actionable insights, expert analysis, and a deeper understanding of how to harness the power of momentum and contrarian strategies in your trading endeavors.

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Transcription

• Speaker #0

  Hello and welcome back to Papers with Backtest podcast.

• Speaker #1

  How great to be back.

• Speaker #0

  Today, we're diving into another algo trading research paper, aren't we?

• Speaker #1

  We are indeed. Always exciting to see what the research world's been up to.

• Speaker #0

  This time we're cracking open abnormal returns with momentum contrarian strategies using exchange traded funds. You know, ETFs are everywhere these days, right?

• Speaker #1

  Oh, absolutely. Seems like everyone's talking about ETFs and for good reason.

• Speaker #0

  It is pretty mind boggling to think, though. That ETFs now represent nearly 35 percent of all U.S. wealth held in those passively managed index type investments.

• Speaker #1

  Yeah, I mean, think about it. 35 percent back in 2005, they were already managing a hefty 300 billion dollars.

• Speaker #0

  So this research paper, right, it dives into, well, you know, can you gain an edge using momentum strategies with them?

• Speaker #1

  That's the million dollar question, isn't it?

• Speaker #0

  Buying those ETFs that have been on a tear. And shorting the ones that have been lagging behind.

• Speaker #1

  The classic momentum play. But it's not just about momentum, is it?

• Speaker #0

  No, not at all. They also look at contrarian strategies. That's right. Which, let me see if I've got this straight, would be buying those underperforming ETFs.

• Speaker #1

  Yeah, kind of betting on a bounce back.

• Speaker #0

  Hoping for a bounce back. Yeah. And shorting the high flyers, thinking they might cool off.

• Speaker #1

  Precisely. It's a bit like going against the grain.

• Speaker #0

  It is. Yeah. But the big question this paper tries to answer, and I think the most fascinating one, is what What timeframe works best? Days, weeks, months?

• Speaker #1

  Yeah, finding that sweet spot. That's the key.

• Speaker #0

  So spill the beans. What did they find? A magic formula?

• Speaker #1

  Well, no magic formula, unfortunately. But some really interesting results. Let's start with momentum. Turns out it does actually work with ETFs. Really? Yep. they found statistically significant abnormal returns.

• Speaker #0

  Okay, we're talking real money here, not just theory, right?

• Speaker #1

  Exactly. And these returns, they become even more pronounced when you hold the portfolio for, let's say, between four and 39 weeks.

• Speaker #0

  So holding on for a few months can really make a difference.

• Speaker #1

  Seems that way. But even more interesting, there was a real sweet spot among those holding periods.

• Speaker #0

  A sweet spot, huh? So what was it?

• Speaker #1

  A 20-week holding period stood out big time.

• Speaker #0

  Okay, so that's like holding for almost Well, almost half a year, right? Yeah. And what kind of return are we talking about here?

• Speaker #1

  Get ready for it. A whopping 13.5% annualized return.

• Speaker #0

  Hold on. 13.5%. That's way above what you'd typically expect.

• Speaker #1

  It is. But, and here's the kicker, it wasn't primarily driven by the winners shooting up even higher. Huh.

• Speaker #0

  Interesting. So what was driving those gains?

• Speaker #1

  The losers. They just kept losing.

• Speaker #0

  The losers kept losing. So it's not so much about chasing those hot ETFs.

• Speaker #1

  Not exactly. It's more about capitalizing on, well, the persistent underperformance of those lagging behind. It's kind of an asymmetry, isn't it?

• Speaker #0

  It is. Okay, that's fascinating. What about the contrarian approach, though?

• Speaker #1

  Right, right. Going against the grain, does it actually pay off? Well,

• Speaker #0

  spill the beans. What did they find?

• Speaker #1

  It does. Contrarian can be profitable, too.

• Speaker #0

  Okay, good to know. But I'm guessing the secret sauce is different, right? Different time frame.

• Speaker #1

  You got it. Contrarian works best over much, much shorter time frames.

• Speaker #0

  Really? Like how short are we talking about?

• Speaker #1

  Well, the most striking result they found, get this, was for a one day holding period.

• Speaker #0

  One day. That's a that's pretty hardcore trading, isn't it? In and out. Boom. But I'm assuming the returns must have been pretty spectacular to make it worthwhile.

• Speaker #1

  They were. They found a staggering 86.9 percent annualized return.

• Speaker #0

  OK, wow. 86.9 percent for one day play. OK, I have to admit that's tempting. But hold on a sec. Wouldn't all those lightning fast trades rack up some serious transaction costs? I mean, those fees could easily gobble up those profits, right?

• Speaker #1

  That's a very valid point. And it's one the researchers didn't shy away from.

• Speaker #0

  Good, good.

• Speaker #1

  They went deep into the nitty gritty of transaction costs.

• Speaker #0

  They looked at those real world expenses.

• Speaker #1

  They factored in those bid-ask spreads, brokerage commissions, the whole shebang. They really wanted to paint a realistic picture, you know.

• Speaker #0

  I appreciate that. So what did they find? Did those costs kill the momentum dream? Nope.

• Speaker #1

  Even after factoring in those costs, the momentum strategies using ETFs, they remain profitable.

• Speaker #0

  OK, that's a relief. So even after paying those pesky fees, there's still money to be made.

• Speaker #1

  Absolutely. They even looked specifically at a 26-week strategy. You know, that's the one that's often recommended.

• Speaker #0

  Oh, yeah. I've heard about that. The 26-week hole.

• Speaker #1

  Right. And even after costs, it still yielded a respectable 4.58% return.

• Speaker #0

  Not bad at all, especially for a strategy that plays out over six months. But hold on. You mentioned something about... a more realistic calculation. Ah,

• Speaker #1

  yes. They also crunched the numbers using something called an effective spread calculation. It gives you a more accurate picture of those costs, you see.

• Speaker #0

  Okay, break it down for me. What's the difference between the regular spread and this effective spread? Are there like... Hidden fees lurking in the shadows?

• Speaker #1

  Not hidden exactly, but it's more about, well, think of it like haggling at a market. You might get a better price than the initial asking price, right?

• Speaker #0

  Okay, I get it. So they factored in this haggling effect. What did that do to the results? Did it boost the returns?

• Speaker #1

  It did. Using that more realistic effect of spread, they found the 26-week strategy actually delivered a 7.01% return after costs.

• Speaker #0

  Wow, that's a pretty big jump. Knowing your spreads can make a real difference.

• Speaker #1

  It really does. It underscores the importance of looking beyond just the surface, you know.

• Speaker #0

  Okay, so far so good. We've got momentum, contrarian, and we've tackled those pesky transaction costs. What about rebalancing, though? I mean, you've got to constantly adjust the portfolio to keep riding that momentum wave and ditch those sinking ships.

• Speaker #1

  You'd think so, wouldn't you? That's the conventional wisdom anyway. But here's another twist. They analyze different rebalancing frequencies, like none at all. weekly, every four weeks.

• Speaker #0

  I'm on the edge of my seat. What did they discover? Is frequent tinkering the secret to success?

• Speaker #1

  The results were actually pretty counterintuitive.

• Speaker #0

  Counterintuitive, huh? Okay, lay it on me.

• Speaker #1

  They found that not rebalancing at all, you know, just letting it ride, actually yielded the best results.

• Speaker #0

  Wait, what? No rebalancing? That goes against everything I've ever heard about active portfolio management.

• Speaker #1

  I know, right? And it gets even more interesting. The results were statistically more significant when there was no rebalancing. It's like a hands off approach is the way to go almost.

• Speaker #0

  Wow. That's a game changer. I always thought constant tweaking was essential, but this research, it suggests otherwise.

• Speaker #1

  It certainly challenges the conventional thinking, doesn't it?

• Speaker #0

  It does. OK, so we've learned momentum and contrarian can work with ETFs, but the time frames are very different. Plus, we might actually want to skip rebalancing. What else did they find?

• Speaker #1

  Well, they dug into different types of ETFs, you know, to see if some worked. better than others with these strategies.

• Speaker #0

  Okay, so they weren't just lumping all ETFs together. They broke it down into different categories all years. What were the categories?

• Speaker #1

  They looked at four main types, domestic, sector, international, and bond ETFs. And here's the thing. Those momentum returns were way higher when they focused solely on domestic and bond ETFs.

• Speaker #0

  Really? Just sticking to those two types gave them a better rate?

• Speaker #1

  Yes. We're talking annualized abnormal returns from like... 44.7% up to 70.9%.

• Speaker #0

  Hold on. Those numbers are seriously impressive. That's a massive difference. So what was their secret? Were those domestic and bond ETFs just like rock stars all around?

• Speaker #1

  Not exactly. Remember how we talked about those loser ETFs driving a lot of those momentum games?

• Speaker #0

  Oh, yeah. The ones that just keep tanking.

• Speaker #1

  Well, that trend was really strong here, too. It was those loser domestic and bond ETFs. They just kept lagging. amplifying the momentum strategy even more.

• Speaker #0

  So it seems like the key to unlocking those crazy returns is to pinpoint those ETFs that are really struggling.

• Speaker #1

  That's a great observation. And whenever they threw in those international ETFs, those returns, well, they just got watered down.

• Speaker #0

  Fascinating. You have to wonder if there's something different about how those domestic and bond ETFs behave. Maybe their dynamics just lend themselves better to these momentum strategies.

• Speaker #1

  That's a really good point. There's definitely something unique about those domestic and bond ETFs. The way they're structured, the way they react to market forces, it makes them more susceptible to these momentum effects.

• Speaker #0

  OK, so we've got momentum, we've got contrarian, the surprising no rebalancing thing. And we found domestic and bond ETFs might be the way to go. What else did they dig into?

• Speaker #1

  Well, let's shift gears a bit. We've talked about the. big picture. But now let's dive into the nitty gritty of their research.

• Speaker #0

  OK, I'm ready to get down and dirty with the details.

• Speaker #1

  Let's unpack the specific trading rules they used in their back tests. You know, the rules they used to try and uncover those abnormal returns.

• Speaker #0

  OK, let's get into those rules specifics. How did they actually test this stuff out?

• Speaker #1

  They followed a pretty classic methodology, actually, you know, building on the work of Jagadish and Tippmann.

• Speaker #0

  Oh, yeah. Those guys like the pioneers of momentum investing. Right.

• Speaker #1

  Exactly. So first they defined. the winner ETFs as the top 10 percent performers over a specific period.

• Speaker #0

  The cream of the crop.

• Speaker #1

  Yeah. And on the flip side, the loser ETFs were the bottom 10 percent.

• Speaker #0

  So it's kind of like separating the wheat from the chaff, right? Yeah. Using past performance to figure out which EPFs are on the rise and which are, well, going down the drain.

• Speaker #1

  Precisely. And get this, they tested different formation periods ranging from one day to a whole year.

• Speaker #0

  Okay. So the formation period. That was their window into the past. They were trying to see if some look back periods worked better than others.

• Speaker #1

  Right. Once they had their winners and losers, you know, for each formation period, they created their momentum portfolio.

• Speaker #0

  Oh, the classic long short strategy. Profit from both sides.

• Speaker #1

  Exactly. And they tested various holding periods, too, you know, matching them to those formation periods. So let's say they used a 20 week formation period, right? They did then. hold that momentum portfolio for 20 weeks before checking the results.

• Speaker #0

  So the holding period was like how long they rode the waves. They were trying to see which holding period hit that sweet spot, right? maximizing profit, minimizing risk.

• Speaker #1

  You got it. Now for the contrarian strategy, they just flipped the script. They bought the loser ETFs and shorted the winner ETFs using the same formation and holding periods.

• Speaker #0

  So instead of writing the momentum, they're betting on like a reversal of fortune, trying to catch that falling knife.

• Speaker #1

  But did it work? Let's look at those results. Remember those amazing annualized returns we talked about for momentum?

• Speaker #0

  Yeah, those were some sweet gains. Well,

• Speaker #1

  those came from formation and hoarding periods ranging from 4 to 39 weeks. Yeah. It seems like that medium term is where the magic happens for momentum.

• Speaker #0

  OK, so holding on for a few months looks good for momentum. But was there a like a specific formation and holding period combo that really knocked it out of the park?

• Speaker #1

  Yes, that 20 week period we talked about earlier, it was a real standout delivering that impressive 13.5 percent return. Remember?

• Speaker #0

  Oh, yeah, that was a big one.

• Speaker #1

  And remember our conversation about the losers continuing to lose?

• Speaker #0

  Yeah, like they don't just underperform. They take a nosedive. That's what was driving those momentum games, right?

• Speaker #1

  Exactly. For example, with that 20-week formation and holding period, the annualized return on the loser portfolio was negative 12.8%.

• Speaker #0

  That's got to hurt. Momentum works both ways.

• Speaker #1

  It does. That's why the short side of the momentum strategy is so important. It's not just profiting from the winners going up. It's also capitalizing on those losers, dragging the portfolio down.

• Speaker #0

  Two-pronged approach. Profits from the rising tide and the falling tide. Okay, let's shift gears to those contrarian strategies. That crazy 86.9% return for the one-day holding period, that's still stuck in my head.

• Speaker #1

  I know, right? It's hard to ignore numbers like that. But as we discussed, gotta be realistic about those transaction costs, especially when you're trading that fast.

• Speaker #0

  Yeah, all those quick trades, they can really add up. Like trying to outrun a cheetah, you might be fast, but those fees, they're relentless.

• Speaker #1

  Exactly. So tempting as that one-day strategy might be. be, you got to weigh those profits against the reality of those costs. Now, before we move on, I got to mention another interesting finding, one that really challenges conventional thinking. Ready for another twist?

• Speaker #0

  Bring it on. I'm starting to think this paper is full of surprises.

• Speaker #1

  They discovered that when it came to rebalancing their momentum portfolios, less was more.

• Speaker #0

  Hold on. Less is more. What do you mean?

• Speaker #1

  They found that not rebalancing at all, you know, just leaving it alone actually led to slightly better results.

• Speaker #0

  Wait, no rebalancing. That goes against everything they teach you about managing a portfolio, doesn't it?

• Speaker #1

  I know, right? It seems counterintuitive, but the data doesn't lie. Even rebalancing weekly or monthly, it didn't improve things. Sometimes it even made it worse.

• Speaker #0

  That's so interesting. Maybe there's something about momentum itself that just works better with a more passive approach.

• Speaker #1

  Maybe so. It definitely makes you think twice about constantly tinkering with your portfolio. Sometimes the best strategy is just to let it ride.

• Speaker #0

  I'm starting to see the wisdom in that. It's like gardening. Sometimes you just gotta let nature do its thing. So does that mean we should just set it and forget it? Never touch our portfolios again? Well,

• Speaker #1

  not quite that simple. This research just shows that a less hands-on approach, especially for momentum, might be better. It's something to consider, something to experiment with.

• Speaker #0

  Okay, so it's not a one-size-fits-all solution. Makes sense. No magic formula.

• Speaker #1

  Right. It's about finding what works best for you, your goals, your risk tolerance.

• Speaker #0

  Okay. So far, we've learned that momentum and contrarian strategies can work with ETFs, but the timeframes are super different. Plus, maybe we should skip the rebalancing altogether. What else did they uncover?

• Speaker #1

  Remember how we talked about those domestic and bond ETFs doing really well?

• Speaker #0

  Oh, yeah. Those are the standouts.

• Speaker #1

  Well, they dug even deeper to see how those strategies performed across different ETF categories and different market conditions.

• Speaker #0

  OK, this is where it gets really interesting. How do those different asset classes behave in different market environments? That's the million dollar question.

• Speaker #1

  Right. So for domestic ETFs, you know, those representing the U.S. stock market. Yeah. They found those ETFs really exhibited strong momentum, especially when the overall market was like in a bullish phase.

• Speaker #0

  OK. So they were riding that wave. Momentum strategies were just capturing those gains as the market went up.

• Speaker #1

  Exactly. But what about bond ETFs? They're a different animal,

• Speaker #0

  right? Right. They're driven by interest rates, not just the overall. market ups and downs.

• Speaker #1

  And, you know, interest rate movements can be a bit unpredictable. So they found bond ETFs. They generally showed weaker momentum compared to those domestic ETFs.

• Speaker #0

  So trying to capture momentum in the bond market, that's a tougher net to crack.

• Speaker #1

  It seems that way. The bond market, it's just a bit more volatile. It makes it harder to ride that momentum wave consistently.

• Speaker #0

  OK, so it's not impossible to profit from momentum in bonds, but maybe you need a different approach, a shorter time horizon.

• Speaker #1

  Exactly. The key here is that asset allocation, it matters. It's not a one-size-fits-all approach. You need to think about which ETFs will work best with these strategies.

• Speaker #0

  It's like choosing the right surfboard for the waves you want to ride. You wouldn't use a long board on choppy water, and you wouldn't use a short board on those big rollers. Each asset class is different, and that affects those momentum effects.

• Speaker #1

  Perfect analogy, and that's why they stressed picking those ETFs carefully. It's about finding the ones that are likely to show strong momentum, and to do that, you've got to understand the nuances of different asset classes.

• Speaker #0

  It's not just about momentum in a vacuum. It's about how momentum interacts with different assets in different market conditions. It's like a... A big puzzle. And all those pieces need to fit together.

• Speaker #1

  I couldn't have said it better myself. It's about seeing the big picture, but also paying attention to all the little details. And as we continue exploring this paper, we'll uncover even more insights to help you solve that puzzle.

• Speaker #0

  I'm ready for more. What else did they find?

• Speaker #1

  They found that how well these strategies worked, you know, the momentum and contrarian ones, it wasn't always the same. It actually changed depending on what the whole market was doing.

• Speaker #0

  OK, so you're saying like. Whether the market was generally up or down, that affected things. The bigger picture matters.

• Speaker #1

  Yeah, exactly. So they saw that momentum strategies, they tended to do better during those bull markets, you know, when prices are generally rising.

• Speaker #0

  Makes sense. When everything's going up, momentum just rides that wave. But what about contrarian strategies? Did they also like those bullish times?

• Speaker #1

  Contrarian, they actually did better during bear markets, you know, when prices are generally falling.

• Speaker #0

  Oh, so it's like... Like they're designed to profit from those dips, those corrections.

• Speaker #1

  Yeah, like a savvy shopper waiting for the sales, you know.

• Speaker #0

  Yeah, I get it. Buy low, sell high, right? Yeah. So it's about being flexible, adapting to the market, right?

• Speaker #1

  Exactly. Bull market momentum might be your friend.

• Speaker #0

  But if it's a bear market, contrarian could be the way to go.

• Speaker #1

  It's all about reading those signals, picking the right strategy for the right conditions.

• Speaker #0

  Couldn't have said it better myself. Always be learning, always be adapting.

• Speaker #1

  OK, so we've covered a lot of ground here. We've got those trading rules, a whole no rebalancing thing. And we've seen that domestic and bond ETFs might be the ones to watch. What else did they find? Any other big takeaways? Well,

• Speaker #0

  remember how those domestic and bond ETFs, they were the stars of the show. Oh,

• Speaker #1

  yeah, they were killing it.

• Speaker #0

  They dug a little deeper into that, you know, examining how things changed when you looked at those different ETF categories and different market situations. OK,

• Speaker #1

  so breaking it down even further. How those specific ETFs performed in different environments. I'm ready. So for domestic ETFs, the ones representing the U.S. stock market, right? They saw that those ETFs, they had like a strong tendency towards momentum, especially when the market was, you know, in a bullish phase.

• Speaker #0

  OK, so they were riding that upward trend. Momentum was capturing those gains as the market climbed.

• Speaker #1

  Exactly. But then with those bond ETFs, remember, they're influenced by interest rates, right?

• Speaker #0

  Right. And those interest rates, they can be a bit unpredictable.

• Speaker #1

  Exactly. So they noticed that bond ETFs, they generally showed weaker momentum compared to those domestic ones.

• Speaker #0

  It's like trying to predict the weather, right? Interest rates can be all over the place. So momentum in the bond market, that's a bit more of a gamble.

• Speaker #1

  It can be, but it's not impossible. It just maybe needs a different approach.

• Speaker #0

  OK, so the takeaway here is asset allocation matters. It's not just about applying these strategies blindly. Can I think about the specific ETFs and how they behave?

• Speaker #1

  Absolutely. Choosing the right ETF for the strategy. That's key.

• Speaker #0

  This is making so much sense. It's not just about momentum by itself. It's about how momentum plays out with different assets and different market conditions.

• Speaker #1

  It's a complex puzzle for sure.

• Speaker #0

  It is. But we're starting to piece it together. So as we wrap up, any final thoughts, any golden nuggets for our listeners to take away?

• Speaker #1

  Well, first off, momentum and contrarian strategies, they can both be profitable with ETFs. It's not about one being better. It's about understanding both and knowing when to use which one.

• Speaker #0

  It's like having different tools in your toolbox, right? Yeah. You wouldn't use a hammer to tighten the screw.

• Speaker #1

  Exactly. And second, remember, those ideal time frames, they're different for each strategy. Momentum likes those medium-term periods, contrarian. It's all about those short-term moves.

• Speaker #0

  Right. And don't forget those costs. Especially for those short-term trades, those fees can add up quickly. Oh,

• Speaker #1

  absolutely. Now, this next one, it might be a little surprising. Sometimes the best thing to do is actually nothing.

• Speaker #0

  Wait, what do you mean nothing?

• Speaker #1

  No rebalancing, especially for momentum. Just letting it ride can actually give you better results.

• Speaker #0

  Wow, that's definitely counterintuitive. But hey, the data doesn't lie.

• Speaker #1

  No, it doesn't. And another thing to remember, those domestic and bond ETFs, they tend to do better than other types when it comes to momentum.

• Speaker #0

  Yeah, they were the clear winners in this research.

• Speaker #1

  So choosing the right asset class, that's important. And last but not least, remember, How those strategies perform, it can change depending on what the overall market's doing.

• Speaker #0

  Right. Bull market, bear market, it all makes the difference.

• Speaker #1

  It does. So be adaptable, read those market signals, and choose the strategy that fits those conditions.

• Speaker #0

  This has been an incredible deep dive. Thank you so much for breaking it all down for us.

• Speaker #1

  My pleasure. Always happy to talk shop.

• Speaker #0

  And to our listeners, 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.