Source: MSCI and Kenneth French Data Library. Calculations by Newfound Research. Past performance is not a predictor of future results. All information is backtested and hypothetical and does not reflect the actual strategy managed by Newfound Research. Performance is net of all fees except for underlying ETF expense ratios.  Returns assume the reinvestment of all dividends, capital gains, and other earnings.

While the results are not as clear as those published by HIMCO, we still see an intriguing effect: returns peak as a function of both formation and holding period. For the country strategy, formation and holding appear to peak between 12-14 months, indicating that an investor using 5-1 month signals would want to hold for 7 months while an investor using 12-1 signals would only want to hold for 1 month.

For the industry data, the results are less clear.  Where the HIMCO and country results exhibited a clear “peak,” the industry results simply seem to “decay slower.”  In particular, we can see in the results for the 12-industry group test that almost all strategies peak with a 1-month holding period.  However, they all appear to fall off rapidly, and uniformly, after the time where formation plus holding period exceeds 16 months.

While less pronounced, it is worth pointing out that this result is achieved without the consideration of trading costs or taxes.  So, while the 5-1 strategy 12-industry group strategy return may peak with a 1-month hold, we can see that it later forms a second peak at a 9-month hold (“14 months since beginning uptrend”).  Given that we would expect a nine month hold to exhibit considerably less trading, analysis that includes trading cost estimates may exhibit even greater peakedness in the results.

Does the Effect Persist for Long-Only Portfolios?

In analyzing factors, it is often important to try to determine whether a given result is arising from an effect found in the long leg or the short leg.  After all, most investors implement strategies in a long-only capacity.  While long-only strategies are, technically, equal to a benchmark plus a dollar-neutral long/short portfolio2, the long/short portfolio rarely reflects the true factor definition.

Therefore, we want to evaluate long-only construction to determine whether the same result holds, or whether it is a feature of the short-leg.

Source: MSCI and Kenneth French Data Library. Calculations by Newfound Research. Past performance is not a predictor of future results.  All information is backtested and hypothetical and does not reflect the actual strategy managed by Newfound Research.  Performance is net of all fees except for underlying ETF expense ratios.  Returns assume the reinvestment of all dividends, capital gains, and other earnings.

We find incredibly similar results.  Again, country indices appear to peak between 12-to-14 months after the beginning of the uptrend.  Industry group results, while not as strong as country results, still appear to offer fairly flat results until 12-to-14 months after the beginning of the uptrend.  Taken together, it appears that this result is sustained for long-only portfolio implementations as well.

Conclusion

Traditionally, momentum is considered a high turnover factor.  Relative ranking of recent returns can vary substantially over time and our intuition would lead us to expect that the shorter the horizon we use to measure returns, the shorter the time we expect the relative ranking to persist.

Yet recent research published by HIMCO finds this intuition may not be true.  Rather, they find that momentum portfolio performance tends to peak 14-to-18 months after the beginning of the uptrend in measured. In other words, a portfolio formed on prior 5-month returns should hold between 9-to-13 months, while a portfolio formed on the prior 12-months of returns should only hold 2-to-6 months.

This result is rather counter-intuitive, as we would expect that shorter formation periods would require shorter holding periods.

We test this result out-of-sample, constructing momentum portfolios using country indices, 12-industry group indices, and 49-industry group indices. We find a similar result in this data. We then further test whether the result is an artifact found in only long/short implementations whether this information is useful for long-only investors.  Indeed, we find very similar results for long-only implementations.

Precisely why this result exists is still up in the air.  One argument may be that the trade-off is ultimately centered around win rate versus the size of winners.  If relative momentum tends to persist for only for 12-to-18 months total, then using 12-month formation may give us a higher win rate but reduce the size of the winners we pick.  Conversely, using a shorter formation period may reduce the number of winners we pick correctly (i.e. lower win rate), but those we pick have further to run. Selecting a formation period and a holding period such that their sum equals approximately 14 months may simply be a hack to find the balance of win rate and win size that maximizes return.

Corey Hoffstein is the Co-founder & CIO at Newfound Research, a participant in the ETF Strategist Channel.

* HIMCO Quantitative Insights, May 2018

** It’s Long/Short Portfolios All the Way Down