Alpha Momentum

Improving the Momentum Factor

May 2018. Reading Time: 10 Minutes. Author: Nicolas Rabener.

SUMMARY

  • Stocks can be ranked by alpha instead of stock returns
  • Alpha Momentum generates a higher and more consistent performance than Price Momentum
  • Momentum crashes are reduced significantly and risk-return ratios increase

INTRODUCTION

Alpha in finance is shrinking continuously as investors are getting better at analysing returns. When a fund manager beat his benchmark 30 years ago, investors likely attributed this to skill. Today a large portion of the outperformance can be explained by exposure to certain factors like Value or Momentum.

The concept of analysing fund manager returns can also be applied to single stocks, which allows investors to decompose stock returns into contributions from certain factors. As with fund managers, not all stock returns can be explained as some companies intrinsically create while others destroy value. Investors can create portfolios by ranking stocks by their alpha generation, speculating that companies with high alphas will continue to generate positive unexplained returns while stocks with low alphas will continue to produce negative unexplained returns. In this short research note we will analyse Alpha Momentum, which is sometimes referred to as Idiosyncratic or Residual Momentum, and contrast the strategy with Price Momentum (read Momentum Factor: Intra vs Cross-Sector).

METHODOLOGY

We focus on the Alpha and Price Momentum factors in the US, Europe and Japan. Alpha is defined as the residual between the stock return and the sum of all factor contributions to the stock returns. The factors used to explain stock returns are the market, Value, Size, Momentum, Low Volatility, Quality, Growth and Dividend Yield. The factor contributions are derived via a regression analysis with a two-year lookback and monthly factor data. Price Momentum is based on the absolute stock performance over the last 12 months, excluding the most recent month. The Alpha and Price Momentum factors are created via a long-short beta-neutral portfolios based on the top and bottom 10% stocks in the US, Europe and Japan. Only stocks with a market capitalisation of larger than $1 billion are included. Portfolios are rebalanced monthly and each transaction incurs costs of 10 basis points.