Cross sectional Momentum FAQ

Standard cross-sectional momentum (SCSM) is an investment strategy which draws upon the law of of motion in physics, mapping onto human psychology traits reflected in  the market such as the persistence of price trends and market confidence such as and investor behavioral biases, overreactiions to news or following herd behavior.  

In short, this stategy theorises that if the target market index has performed a certain way for a period in time, it is highly likely that it will continue to behave that way for an equal amount of time in the future.   Investors hope that by going long on winners and short on losers, they can capitalize on price momentum.

The strategy ranks stocks within a particular index or market based on their past performance, typically over 3, 6, or, 12 months. Investors buy (go long) the top-performing stocks and sell (go short) the underperformers, expecting these trends to continue in the short to medium term.  

For example: 

A10% long/short strategy can be applied to the S&P500, where the past 180 days are analysed to find the top 10% of performers, or 50 companies and the bottom 10% of the companies.   Then an equally weighted portfolio of $100,000.00 is created where the top 10% are bought and the bottom 10% are short sold for the next 180 days.   This cross-section portolio is held for 6 months counting on the momentum those companies have displayed.    

This somewhat simple analsys usinig the S&P500 which already has a lot of market confidence, has the potential to perform better than simply buying an S&P500 spread.  When the strategy works, a standard CSMA portfolio can out portfolio will outperform the S&P500 by several points during the relevant timeframe. 

The strategy relies on the persistence of price trends and investor behavioral biases, such as overreacting to news or following herd behavior. Investors hope that by going long on winners and short on losers, they can capitalize on price momentum.

Yes, empirical research supports its effectiveness. In a seminal 1993 study,  Jegadeesh and Titman found that momentum strategies could generate significant positive returns, especially when stocks are held for 3 to 12 months after ranking. Further studies, like Asness, Moskowitz, and Pedersen’s (2013) research, have validated its success across different markets and periods.

• Institutional Investors such as hedge funds and asset management firms, who use sophisticated tools to analyze large datasets and exploit momentum signals.
• Quantitative Traders who rely on mathematical models and algorithms to identify trading opportunities.
• Advanced Retail Investors with access to advanced platforms and a deep understanding of market dynamics, though less common due to the complexity involved.

When leveraged properly, momentum strategies can be used to mitigate market volatility, however if simplistically implemented, it can amplify volatility depending on sudden shifts in the market, or epoch changes. For example: 

Volatility Mitigation:

• Diversification: By balancing long and short positions, investors can spread their risk across multiple assets.

• Dynamic Adjustments: Momentum portfolios are often rebalanced regularly to adapt to changing market conditions.

• Counterbalancing: Long-short portfolios can act as a hedge, reducing the impact of market volatility on the overall portfolio.

Volatility Amplification:

• Chasing Trends: Momentum strategies can lead to buying high and selling low if market trends reverse quickly.

• Herding Behavior: Multiple investors chasing the same trends can amplify market movements, increasing volatility. 

• Sensitivity to Market Changes: Momentum strategies may struggle during periods of rapid market reversals or high volatility. Machine learning models can predict and detect such changes, offering early warnings to exit trades when necessary.

Investors typically use several risk management techniques, such as:

• Volatility Targeting: Adjusting position sizes based on market volatility.

• Stop-Loss Mechanisms: Setting stop-loss orders to limit potential losses during market reversals.

• Tail Risk Hedging: Using options or derivatives to protect against extreme market movements. 

 Momentum strategies began gaining traction in the early 1990s, although the concept of momentum in financial markets has been observed for much longer.

Key Milestones:

1. Pre-1990s: Traders and investors noticed that stocks which performed well tended to continue performing well, but this wasn’t systematically studied.

2. 1993: The strategy was formally recognized with Jegadeesh and Titman’s paper, “Returns to Buying Winners and Selling Losers,” which demonstrated the potential for significant positive returns.

3. 1990s onwards: Institutional investors, particularly quantitative hedge funds, began widely adopting momentum strategies. Its popularity has continued to grow, with the development of quantitative trading models and algorithms.

SCSM, as described above, is a somewhat simplistic approach. It selects an index, such as the S&P 500, reviews performance over a 3, 6, or 12-month period, and identifies the top and bottom performers in the observed timeframe. A portfolio is then created by going long on the top performers and short on the bottom performers, holding it for the same time period.

As discussed, in Q's 3 and 5,  this strategy is somewhat safe, since it relies on the strength of index related companies. The strategy diversifies across a number of holdings, and relies on market trends over a longer hold period and can produce better returns.  This can mitgate volatility, and  counterbalance against volatility.   However there are risks and flaws related to this strategy, that can seriously erode profits and at times produce overall losses. 

8.1 Profit Erosion Risks based on Simplistic SCSM Strategy - Traps

Trading using SCSM strategies has some inbuilt traps.  For example; If a company share price that is bought and held long, drops all of a sudden due to unforseen market trends reversing, based on the simplistic strategy, or a company share price that is short sold, bounces, profits begin to be eroded at the center of the portfolio.  If both of these events occur across the portfolio, average profits can significantly decrease and at times a loss can be suffered and SCSM portfolios can and do perform below the index. and can result in an overall loss.     

At Arcanero we call these: 

Bull Traps: where the investor believes its a bullish company, and buys long, but the share price drops), and;  

Bear Traps: where the investor beleives its a bullish compamy  and short sells, but the share bounces.  

8.2 Risk of Inflated Tranaction Costs

As the answer in Q 3 explains, Standard Cross Sectional Momentum can mitigate some of these 'traps' by rebalancing the portfolio from time to time by changing asset allocations, however there are increased transaction costs associated with this mitigation strategy that erode profits, including: 

1. Transaction Costs aka Churn. 

• Brokerage Fees: Every time a portfolio adjustment is made, whether buying or selling shares, a brokerage fee is incurred. Frequent adjustments can lead to accumulating these fees over time.
• Spread Costs: The bid-ask spread (the difference between the buying price and selling price) can add additional costs. The more frequently trades are executed, the more spreads are paid.

2. Taxes

• Capital Gains Taxes: When assets are sold for a profit, capital gains taxes may apply. If portfolio adjustments involve realizing profits regularly, taxes can significantly impact the portfolio’s returns.
• • Short-term vs. Long-term Gains: Frequent adjustments may lead to short-term capital gains (which are usually taxed at a higher rate), as opposed to long-term gains, which are taxed at a lower rate.

3. Market Impact Costs

• Liquidity Issues: If large trades are made in a less liquid market, the portfolio manager may have to accept less favorable prices, leading to higher costs.
• Price Slippage: Rapid market movements during large trades can lead to slippage, where the execution price differs from the intended price, increasing costs.

4. Opportunity Costs*

• Missed Gains: Over-adjusting the portfolio in response to short-term market fluctuations can lead to missing out on long-term gains, especially in the case of overreacting to volatility.
• Loss of Compound Growth: Selling assets prematurely or frequently interrupts the compounding effect that long-term investments might provide.

5. Management Costs

• • Increased Analytical Costs: Dynamically adjusting the portfolio requires ongoing analysis and monitoring, which can increase the costs associated with portfolio management.
• • Higher Advisory or Management Fees: If a financial advisor or portfolio manager is involved, frequent adjustments may lead to higher management fees, especially if the fee structure is based on the level of activity.

In short, at Arcanero, we have indentified problems with SCSM simplistic strategies, which include the risk of bull traps and bear traps, and further, we have identified increased costs associated with SCSM trap mitigation strategies that can erode the overall returns of the portfolio, particularly if the benefits of dynamic adjustments (such as risk management or optimized returns) don’t outweigh the additional expenses.   

We determined that the way to avoid these losses is to focus on using our proprietary ML strategies in our Momentus product to identify and remove as many of  these traps as possible.  This strategy has a 2 pring effect.   First, profit erosion due to traps is minimised, and second, costly mitigation solutions such as rebalancing, are not necessary.  Thus, lowering transaction costs, churn, profit erosion, while increasing consistent reliable returns in cross sectional momentum portfolios. 

- 

-