Understanding Momentum

Abstract

The extensive literature on price momentum effects is a potential source of confusion for portfolio managers because conflicting explanations give rise to different implications for portfolio strategy. Analysis of the value-weighted large-capitalization universe represented by the MSCI World Index indicates that price momentum is driven largely by industry momentum, not individual-stock momentum, and that it is not a result of cross-sectional dispersion in industry mean returns or varying industry exposure to systematic risk. In a small-cap universe, stock-specific effects assume greater importance. For sample periods 1992–2003 and 1980–2003, value investors would have reduced risk by imposing sector neutrality on their portfolios whereas growth managers could have profited by relaxing sector constraints.

The extensive literature on price momentum effects is a potential source of confusion for portfolio managers because conflicting explanations give rise to different implications for portfolio strategy. Is momentum a stock-level phenomenon, or is it subsumed by industry or style effects? What are the performance implications of imposing sector or style neutrality on portfolio strategies? How does price momentum affect estimates of tracking error or Sharpe ratios?

We found that in a value-weighted large-capitalization universe, such as the MSCI World Index, price return momentum is driven largely by industry momentum; it does not appear to be explained either by country or individual-stock momentum. Furthermore, return continuation in this universe is not a result of either cross-sectional dispersion in industry mean returns or of varying industry exposures to systematic risk. In broad universes, such as the Dow Jones Global Index universe, stock-specific effects assume greater importance. We demonstrate that these results are broadly consistent with previous research if that research is differentiated by the breadth of the authors' data sample and by whether they value-weighted or equally weighted their momentum portfolios.

We used two approaches to decompose momentum returns. The first approach was to compare the average return to long–short momentum portfolios constructed at the stock level with the average return to such portfolios constructed at either the sector or country level. We show that in a value-weighted large-cap universe, the sector momentum strategies can generate a magnitude of return that is similar to the return of stock-level momentum strategies. The second approach was to decompose the returns to the stock-level momentum strategies by using the “random coefficient" approach. We demonstrate that a significant proportion of the returns to these strategies can be attributed to the sector and country factors.

Over both our sample periods, January 1992 through March 2003 and January 1980 through March 2003, value investors would have reduced risk by imposing sector neutrality whereas growth managers could have profited from both a growth strategy and a momentum strategy by relaxing sector constraints, although the effects would have been stronger for the more recent past. In practice, any group of companies sharing a common characteristic has the potential to exhibit price momentum. Such a characteristic could be as simple as industry or country—or any characteristic that investors expect to affect performance. Controlling the risk in any portfolio, therefore, requires monitoring style exposure.