Essays24.com - Term Papers and Free Essays
Search

Momentum Trading

Essay by   •  March 11, 2018  •  Research Paper  •  2,243 Words (9 Pages)  •  246 Views

Essay Preview: Momentum Trading

Report this essay
Page 1 of 9

Momentum Trading

[pic 1]

Executive Summary

        This is the last of three reports analyzing the effectiveness of momentum trading as an investment strategy. Included in this report are summaries of the findings of reports one and two. In the first report, information was gathered about momentum trading as an investment philosophy. In the second report, this information was used to create the groundwork for the investment strategy used in a mock portfolio. The mock portfolio was made up of 8 stocks that were bought and held and 7 stocks that were shorted. 15 was chosen as the number of stocks, because there are diminishing returns to the diversity of the portfolio for any number of stocks held greater than 15. The portfolio was held from November 10th to November 27th, and it saw returns of 3.29%, outperforming the S&P 500 by 3.19%.

Introduction

This is part three of a three-part report in which a portfolio is created and analyzed to determine the effectiveness of a momentum investing strategy. The first section of this report is a summary of report 1. In this section, the philosophy behind momentum investing is discussed, quantitative and qualitative data supporting momentum investing is provided, and a case study about momentum investing (AQR Momentum Funds) is discussed. The second section is a summary of report 2. Report 2 broke down the specific investment strategy that would be later used to create the mock portfolio, and it explained why the stocks that were chosen were selected. The last section of the report looks at the results of the mock portfolio, and it analyzes the effectiveness of the investment strategy.

Summary of Previous Reports

Summary of Report 1

Report 1 took a look at what momentum investing is and why it is a valid investing strategy. Momentum investing is the foundation behind a large number of successful trading strategies. It has received considerable interest from academic researchers over the last 20 years and has been shown to be a consistent source of high risk-adjusted returns. Momentum investing seeks to take advantage of current trends in the market. The basic concept of momentum investing is that all stocks are ranked based upon their performance over the formation period with the best performing stocks being assigned to the winner portfolio and the worst performing stocks being assigned to the loser portfolio.

The study done by Fama is the inspiration behind this report’s investment strategy. The strategy implemented by Fama involved ranking all stocks based on their past 12-month return, ignoring the most recent month, then entering into a long position in the top 10 percent of stocks and a short position in the bottom 10 percent of stocks. When applied to historical data, Fama found returns that exceeded those of the S&P 500 over a time period of over 60 years (Fama, 1998).

The reason momentum investing works has a lot to do with psychological biases that affect human investors. Investor Herding, or herd behavior, is the tendency for individuals to mimic the behavior of larger groups, specifically when the individuals would not make the same decision when acting alone. There are two main reasons why investor herding happens. The first reason is social pressure. Humans have a natural desire to be a part of a group, so it may be difficult for investors to make decisions that go against the trend of other investors. The second is the idea that it’s not likely that such a large group is wrong. If an investor sees that a stock is rapidly going up in price, they may instinctually feel that there must be some merit to the stock, even if the financials do not entirely check out. Another psychological bias is investor over and under reaction. Investor over and under reaction is a market hypothesis stating that investors have the tendency to react disproportionately to market news. This results in the price of the stock changing dramatically, and the price will not accurately reflect the true value of the stock for some time after the event. Investors get optimistic when a stock or the market goes up, and assume it will continue to do so.

The AQR Momentum Funds Case is a valuable tool for this report. AQR is a fund management company established in 1998 by Clifford Asness, David Kabiller, Robert Krail, and John Liew and is headquartered in Greenwich, CT. At the time of the case, AQR was considering the launch of three new retail mutual funds that would offer investors exposure to Momentum. AQR, in the beginning, only offered hedge funds, which are primarily geared towards high net-worth individuals and clients. The mutual funds that AQR was considering offering were different from hedge funds in several ways. First, mutual funds are offered to all investors, not just those of high net worth. Second, hedge funds often take both long and short positions, whereas mutual funds are limited to long positions only. Finally, mutual funds must be open ended, meaning investors can sell their shares at any time. Hedge funds are typically closed to entry and exit until the end of the period (Bergstresser, D., Cohen, L., Malloy, C., 2012). These differences between hedge and mutual funds are important to consider when looking at AQR’s choice as to whether or not to invest in momentum as a strategy.

The case looks at a strategy created by AQR, the AQR long-only momentum index. The AQR index was created by taking the top 1/3 best performing stocks over the past 12 months (ignoring the most recent month), and combining them into a portfolio based on market capitalization (Bergstresser, Cohen, Malloy, 2012). This created a valuable benchmark, and also created another tool that could be applied to historical data. This benchmark ignores the shorting aspect of momentum investing. The Russell 1000 index looks at 1000 different large-cap stocks that are weighted based on market capitalization, similar to AQR’s own large-cap index. When compared to the Russell 1000 benchmark, the AQR large-cap momentum index outperformed it by 210 basis points per year since 1980 (Bergstresser, Cohen, Malloy, 2012). This is another example of momentum trading outperforming a historical benchmark.

Taking a look at the results of the AQR case is valuable for building a case for momentum as a strategy. In the end, no final decision was reached by AQR. AQR could not use the momentum strategy to its full potential in their mutual fund products as they were limited by law, and could not take short positions and use excessive leverage. This left AQR with only one option for momentum investing, and that was tracking past winners. This effectively hampers AQRs ability to maximize on momentum investing. Moreover, 2 out of 3 of their momentum funds are going to be constrained to large cap stocks in the US and globally. Large cap stocks are, in general, more likely to have lower risk and slower growth than small cap stocks. It will be useful to look at these limitations when deciding the investment strategy for this report.

...

...

Download as:   txt (13.2 Kb)   pdf (341.2 Kb)   docx (353.7 Kb)  
Continue for 8 more pages »
Only available on Essays24.com
Citation Generator

(2018, 03). Momentum Trading. Essays24.com. Retrieved 03, 2018, from https://www.essays24.com/essay/Momentum-Trading/83562.html

"Momentum Trading" Essays24.com. 03 2018. 2018. 03 2018 <https://www.essays24.com/essay/Momentum-Trading/83562.html>.

"Momentum Trading." Essays24.com. Essays24.com, 03 2018. Web. 03 2018. <https://www.essays24.com/essay/Momentum-Trading/83562.html>.

"Momentum Trading." Essays24.com. 03, 2018. Accessed 03, 2018. https://www.essays24.com/essay/Momentum-Trading/83562.html.