Momentum serves as a salient case study. Basic momentum formulations make use of each stock's past total returns, usually the period from 12 months to 1 month prior to investment. Stocks with higher past returns, by this measure, are deemed attractive to own, while stocks that have performed comparatively poorly are excluded from long-only portfolios or, in long-short implementations, sold short.
But strategies based on this rudimentary formulation might be vulnerable to unintended risks. They tend to display significant and pro-cyclical variation in their market exposure over time, as portfolios load up on high-beta names when the market is rallying and on low-beta names during declines. As well, they may unwittingly take on material sector exposures and participate in crowded trades. Simple momentum formulations also may respond to different aspects of investor behavior as market conditions change. They may reflect market-level sentiment when correlations among stocks are high and company-specific views when correlations are low.
Empirical evidence suggests that more sophisticated formulations of momentum may produce superior risk-adjusted returns than simplistic measures. One example, residual momentum, is a regression-based formulation that seeks to reduce time-varying risk factor exposures in the signal and better isolate stock-specific sentiment. Another example, a factor that our firm calls peer momentum, attempts to extract more nuanced sentiment information about a stock from price trends affecting groups of related companies.
Our work has shown that these formulations generate more stable performance and higher Sharpe ratios over time, experiencing smaller drawdowns and less vulnerability to crowded trades. In 2016, for example, a rudimentary long-short momentum formulation likely would have experienced material losses, whipsawed by short positions in high-beta industrials and oil-related stocks as stock and crude oil prices recovered from prior losses. Our analysis suggests that residual and peer formulations would have fared better during this episode.