Profitable Momentum Strategies for Individual Investors
Get ready to delve into the world of momentum strategies as this research sets out to discover if individual investors can attain consistent profitability. A myriad of research and years of study reveal that momentum strategies can reach stable returns in a variety of financial markets. Most of these studies pertain to institutional and professional level funds that have greater access to capital than individual investors.
But can individuals attain such profitability with momentum strategies?
With only 0.6% of mutual funds outperforming the benchmark index, many individual investors have limited opportunity to gain alpha. Furthermore, individual traders have more limitations than professional investors such as high trading costs and selling constraints. Even popular funds, like AQR Capital which utilizes momentum strategies, has a minimum initial investment of $5 million.
So the quest to determine if the barrier to entry could be lowered for individual investors through a simplified strategy that utilizes topside momentum begins. The methodology is relatively simple: the study starts by taking all of the delisted and listed stocks using Thomson Reuters DataStream (this is to avoid survivorship bias) and filtering out illiquid stocks with less than $20 million. Then each instrument was ranked from highest performer to lowest based on a six month formation period. The best performers were bought at the close price of the first day of trading directly after the six month formation period. The holding period for the first test lasted 12 months the results revealed that this basic strategy outperformed the S&P 500 by 0.5% to 2.44 % per month.
However, investors cannot naïvely adopt a trading strategy without first taking transaction costs and volatility into consideration. The general transaction costs plus the spread and nominal SEC fee were added into the equation next and tested on various initial investments from $5,000 to $1 million dollars on the same data. The researchers accounted for systematic risk using the CAPM and Fama-French models and the results were astounding. Monthly alpha remained, on average, at 1.5% per month or higher for accounts with two to ten equities in their portfolio. The only exception to these results was during a financial crisis as the momentum strategy had relatively large losses during the financial crisis of 2007 and 2008. Be sure to check out the research paper to see the returns of each combination of trading frequencies on each initial investment.
Monthly, bi-monthly, quarterly, tri-yearly, bi-yearly and yearly trading frequencies were also tested on the various initial investment amounts. Understandably, higher trading frequency increases transaction costs as trades were closed and reopened more frequently. In order to be successful, the volatility needs to decrease at a higher rate than performance as frequency increases.
The data concludes that it is, in fact, possible for individual investors with smaller account sizes to achieve profitability by utilizing topside momentum strategies. The ideal trading frequency was monthly to bi-yearly for lower balance accounts trading five to eight of the top performing equities in the market.
To read the full study by Bryan Foltice and Thomas Langer, click here.
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