Industry Momentum and Sector Mutual Funds

Abstract

Recent academic research has ascribed the intermediate-term (3-month to 12-month) momentum present in U.S. stock returns to an industry effect. In the intermediate term, strong (weak) industry performance is followed by continued strong (weak) industry performance. The industry-specific aspect of momentum gives rise to profitable trading strategies that use industry-sector mutual funds. In this study, strategies of buying previous intermediate-term top-performing sector funds outstripped the S&P 500 Index over the 10-year period from May 1989 through April 1999 on a total-return basis. These strategies entailed greater total and systematic risk, however, than the index.

U.S. stock returns exhibit momentum over 3-month to 12-month time frames. This tendency for intermediate-term performance to persist has recently been ascribed in the academic literature to an industry effect: Well-performing industries continue to outperform while poor-performing industries continue to lag.

Can practitioners exploit this industry momentum? The jump from identification of patterns in stock market returns to strategically capitalizing on the patterns is difficult in many cases. Academic studies often rely on the formation of hedge portfolios that require extensive short selling, a strategy that some practitioners may be hesitant to use. In addition, such studies often use the entire universe of stocks, whereas practitioners are limited (because of the sheer size of the universe) to a subset of all traded stocks. Finally, the market-impact costs caused by trading large numbers of stocks are often difficult to measure. For practitioners, therefore, an industry momentum strategy that uses industry-sector mutual funds has two advantages: It minimizes the number of securities that must be followed, and the trading costs are known. It also has two disadvantages: Sector funds are actively managed (and thus do not represent a passive or pure play on an industry) and sector funds charge significant annual fees. To determine whether the advantages outweigh the disadvantages, I examined the success of various portfolio strategies designed to use sector funds to exploit industry momentum.

The methodology entailed a rolling procedure of forming portfolios of sector funds over a series of lag and hold periods. I used 10 years worth of historical data covering the period May 1989 through April 1999. The portfolios were formed on the basis of the returns in a lag period of 3, 6, or 12 months. These portfolios were then assumed to be bought and held over a subsequent holding period of 3, 6, or 12 months. At the end of the holding period, the portfolios were sold and new portfolios were formed on the basis of the most recent lag period. I calculated annualized returns and risk measures for the portfolios.

Over the 10-year period, industry momentum was strong in sector mutual funds. Depending on the length of the holding period, portfolios of previous top-performing sector funds outperformed previous bottom performers by as much as 14 percentage points a year on average. Industry momentum appears to have been strongest for holding periods of 12 months but was also evident for 3- and 6-month holding periods. Of potentially greatest interest to practitioners is the performance of the strategies that bought previous top performers when compared with the performance of relevant market indexes: Ten out of twelve strategies with holding periods of 12 months outperformed the S&P 500 Index over the sample period, and the strategies performed even better against benchmarks from the mutual fund universe.

The sector mutual fund strategies entailed greater total risk, however, than the market indexes used in the study. Sharpe ratio comparisons indicate that the sector fund portfolios failed to outperform the S&P 500 after compensating for total risk as quantified by standard deviation. The sector fund strategies also led to higher systematic risk, but the returns to the strategies completely compensated for the additional systematic risk.

Finally, I found industry momentum to be significantly related to economywide default risk premiums. Industry momentum was strongest in an environment of declining default risk, which suggests that the market views top-performing industries as relatively risky investments that benefit when default risk premiums decline.