Friday, April 12, 2019

Factor Momentum - An important property for portfolio building

An investor who buys the top performing factors and sells the poor performing factors will improve the portfolio performance comprised of different well-known equity factors. This momentum is not the same as the well-known stock momentum factor and seems to be an independent property of investment factors. Momentum can be found almost anywhere within the investment world.

As shown by Gupta and Kelly in their deeply researched paper, "Factor Momentum Everywhere", there is time series persistence in most equity factors. The authors studied 65 different characteristic-based factor portfolios that have all been documented in leading academic journals and found that the majority has persistence that is meaningful. See their paper for the complete list of factors analyzed.

Some may think of this evidence of persistence as just an interesting anomaly. The importance of momentum is not just in the underlying assets but also in the risk factors that define returns. Nevertheless, this property has important implications for portfolio construction. Investors can time factors and construct improved dynamic portfolios over a static factor allocation. 

Their time series factor momentum portfolio (TSFM), which bundles all the factors with momentum, has both strong alpha and a high Sharpe ratio. This time series effect is much stronger than what would be found through a cross-sectional approach across factors. 

As found with other momentum models, this effect is present for many different look-back specifications. It is strong in the short-run as well  as for longer-term memory structures. Factor momentum is a robust effect. A significant allocation to TSFM also is present when forming ex post tangency portfolios. 

This research suggests that there can be exploited persistence when forming portfolios of alternative risk premia that proxy factors. It provides a simple framework for increasing exposure to positive performers and selling those factors (risk premia) that have shown recent negative performance. As a macro-focused manager, I am interesting is studying whether this persistence is also present with other asset class factors. If factor momentum is everywhere, investors do not have to be limited to volatility or risk equalization portfolios. Momentum used as an expected return measure and coupled with optimization can improve portfolio performance. 

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