Evidence Investing

 
Momentum 1.5 05/03/2010
 
I wanted to add one more paper to my ‘Basics of Momentum’ series.  I hope that by now you are beginning to admit that momentum truly exists as a unique phenomenon.  As I have said, we are going to get into how to maximize it and practically use it on a daily basis to invest more profitably.

#8:  Review of  “Relative Strength Strategies for Investing”.   In this excellent paper by one of the giants in the relative strength/TAA arena, Mebane Faber (check out his blog here) looks at the basics of momentum as well as  a few strategies to maximize its employment in an investing strategy.  We are going to be looking at this paper again when we start getting into combinations and practical applications of this style of trading, so here I am just going to pick and choose what I highlight…and believe me, I am saving the best for later.

Abstract:      The purpose of this paper is to present simple quantitative methods that improve risk-adjusted returns for investing in US equity sectors and global asset class portfolios. A relative strength model is tested on the French-Fama US equity sector data back to the 1920s that results in increased absolute returns with equity-like risk. The relative strength portfolios outperform the buy and hold benchmark in approximately 70% of all years and returns are persistent across time. The addition of a trend-following parameter to dynamically hedge the portfolio decreases both volatility and drawdown. The relative strength model is then tested across a portfolio of global asset classes with supporting results.

In this paper he looks at over 80 years of data from 10 sectors of US equities versus the returns of the S&P for the same period.  Individually, any one of the sectors showed little/no advantage over the market or over a equally weighted portfolio of all the ten sectors, either in absolute returns or with risk adjusted returns (Sharpe ratios).
Picture
Picture
Then he employs a simple trading rule…which is the essence of momentum: on a monthly basis, rank the sectors based on recent monthly returns (either 1, 3, 6, 9, 12 month returns, depending which ranking period he was testing).  Then he constructed an equally weighted portfolio of the Top 1 performing sectors (top sector only), Top 2 (top two sectors only) performing sectors, and so on up to the top 10 (all sectors, which IS the Equally Weighted portfolio). 

Here’s what he found:   
Picture
Click for a full size image
Here’s a graph of the Equally Weighted portfolio and the Top 1, 2, and 3 momentum portfolios:  
Picture
And finally, here is a table of the Top 1-3 portfolio’s out-performance: 
Picture
This shows an amazing 3.25% to over 5.5% out performance!  WITH improved drawdowns, significantly better Sharpe ratios in every case!  It out performs buy and hold about 70% of the time, as well.  This is a superbly elegant way to show how powerful momentum/relative strength and asset allocation really is.

Now, turnover is an issue, and trading frictions as well, but I will get to those soon enough.
 


Comments




Leave a Reply