Blog Posts — January 29, 2019

Factor Performance Can Be Timed and Exploited, Study Finds Factor Performance Can Be Timed and Exploited, Study Finds

Investment factors such as size or value have a ‘robust’ momentum profile that allows investors to time their future performance based on recent returns, according to a study1 published by researchers at AQR Capital Management LLC.

A portfolio strategy that buys the recent top-performing factors and sells poor-performing ones achieves significant returns performance above and beyond traditional stock momentum, authors Tarun Gupta and Bryan Kelly wrote. This ‘factor momentum’ strategy also beat industry momentum, value, and other factors in terms of Sharpe ratio, a measure of risk-adjusted returns.

The research paper analyzed the performance of 65 equity factors based on long-short portfolios around the world and under different time frames.

“Factor momentum adds significant incremental performance to investment strategies that employ traditional momentum, industry momentum, value, and other commonly studied factors,” Gupta and Kelly wrote. “Their results demonstrate that the momentum phenomenon is driven in large part by persistence in common return factors and not solely by persistence in idiosyncratic stock performance.”

“Factor momentum earns an economically large and statistically significant alpha after controlling for stock momentum,” they added.

AQR is an investment management firm based in Greenwich, Connecticut, with almost $200 billion under management; it is known for its applied research in investment strategies.

Large and significant alpha

Price momentum is the well-researched observation that assets that have outperformed in the recent past will continue to do so in the immediate future, and vice versa. The authors’ argument adds to the debate on whether factor performance can be predicted, with past studies focusing on characteristics such as valuation proving less conclusive.

A starting point in the analysis was the establishment that individual factors exhibit robust time-series momentum, meaning that their performance is persistent (in an absolute sense rather than relative to a peer group) and therefore predictable.

“Persistence in factor returns is strong and ubiquitous,” they wrote.

Multi-factor does best

The study also concluded that a combined strategy that averages one-month time-series momentum of all factors exceeded the performance of any individual factor’s time-series momentum. This strategy performed similarly well with longer formation windows.

The factors’ excess returns shown in the analysis remained after trading transaction costs.

STOXX’s factor strategies

Factor investing has been a very popular strategy since academics first uncovered new sources of systematic risk in the 1990s. In a STOXX paper2 published in April 2016, an analysis found that six factors – value, carry, momentum, size, low risk and quality – provided significant excess returns to their benchmark while also offering marked decorrelation.

STOXX manages a series of factor-based indices that seek to exploit widely-acknowledged sources of market-excess returns, so-called risk premia. The EURO STOXX® Multi Premia® and Single Premium Indices integrate the academic methodology of STOXX’s partner Finreon, and track seven sources of equity risk and returns: value, reversal, low risk, residual momentum, momentum, quality and size. Their universe is the EURO STOXX® Index of Eurozone equities.

The EURO STOXX Multi Premia Index provides a blend of risk premia sources that leads to consistent outperformance to the benchmark throughout market cycles.

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1Gupta, T., Kelly, B., ‘Factor Momentum Everywhere,’ Nov. 1, 2018 (publ. Dec. 31, 2018).
2Plagge, J.-C., ‘iSTOXX Europe Factor Indices – An Investable Access to Factor Risk Premia,’ STOXX, Apr. 26, 2016.