Q3AM Momentum White Paper

7/30/2019 Q3AM Momentum White Paper

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Momentum Investing

An Empirical Study

A White Paper by: Q3 Asset Management

Adam Quiring Principal Partner Bradford Giaimo Principal Partner Eric Detterman Research & Strategy Development

December, 2012


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Momentum Investing: An Empirical Study

Copyright 2012 Q3 Asset Management

All rights reserved. No part of this publication may be reproduced, stored in aretrieval system, or transmitted, in any form or by any means, electronic,mechanical, photocopying, recording, or otherwise, without the prior

permission of the copyright owners.

All brand, company, and product names are used for identification purposesonly and may be trademarks that are the sole property of their respectiveowners.

This white paper may provide general investment information from sourcesdeemed reliable but is in no way a solicitation to buy or sell any security. Past

performance is not indicative of future results. There is no assurance that anystrategy presented herein will succeed in the future. Data is provided for informational purposes only and should not be construed as investment

advice. There is risk of loss with all investment strategies. All data isconsidered hypothetical. Hypothetical performance results have certaininherent limitations. Unlike an actual performance record, simulated tradesdo not represent actual trading. Also, since the trades have not actually beenexecuted, the results may have over or under compensated for the impact, if any, of certain market factors such as lack of liquidity. You may have done

better or worse than the results portrayed. Hypothetical testing does notinvolve financial risk and therefore may not necessarily depict an investorsability to tolerate such risks. Mutual funds used in the research for this white

paper may or may not be available to use in the future. Additionally, suchfunds may not have always been available on a specific trading platform inthe past. Historical data used in testing is provided by Commodity Systems,Inc. (CSI) and Morningstar. Results do not take into consideration any taxconsequences that may arise from an active investment approach.


Document No.: 201201

Published by Q3 Asset Management, December 1, 2012

Any comments or questions relating to the material contained in thisdocument may be submitted to:

Q3 Asset Management2175 Cole StreetBirmingham, MI 48009

(248) 566 1122

[email protected]

www.q3tactical.com A W h i t e P a p e r P u b l i s h e d b y Q 3 A s s e t M a n a g e m e n t 2
mailto:[email protected]:[email protected]:[email protected]


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Table of Contents

Executive Summary 4

Background 5

Active vs. Passive Investing ............................................................................... 5

Removing Emotion - The Key to Success .......... .......... ........... .......... ........... ...... 6

Momentum Investing 7

Momentum Definition ........................................................................................ 7

Momentum Research .......... ........... .......... ........... .......... ........... .......... ........... ...... 7

Momentum Strategy Background ....................................................................... 8

Momentum Strategy ........................................................................................... 8

Momentum Strategy Within Market Environments .............. ........... .......... ...... 10

Conclusion 12

About the Authors 13

Eric Detterman ................................................................................................. 13

Adam Quiring ................................................................................................... 13

Bradford Giaimo .......... ........... .......... ........... .......... ........... .......... ........... .......... . 13

About Q3 Asset Management 13



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Executive Summary

For years, investors - both professional and amateur alike, have been attempting tobeat the market. The efficient market hypothesis asserts that it is impossible to doso with less risk than a buy-and-hold approach. Severe market downturns coupled with emotionally driven investors have led retail investors to underperform. Researchshows that during times of stock market duress, retail investors exit their positionsand re-enter the equity market as conditions improve, often at higher prices. This

research shows that as a result of these actions the average investor underperforms the benchmark.

We present a rule-based momentum investing approach which removes emotion fromthe investment process. The system is based upon the market phenomenon of trend

persistency. The system presented outperforms a value-based system (buyingweakness) and passive approach on both an absolute and risk-adjusted basis. We thenimprove upon the momentum system by analyzing the broad market environment

prior to re-allocating. The resulting momentum strategy within market environments presented outperforms a pure momentum system, value-based system and benchmark on an absolute and risk-adjusted basis over the 20+ year test period.

The momentum research described in this paper can be applied in many ways and implemented across numerous investment products.



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BackgroundThe New York Stock Exchange opened its doors in the late 1700s and ever since, investors - both professional and amateur alike, haveattempted to beat the market. Quantitative investment strategists have

been on an endless pursuit to identify the holy grail of investing. Their objective is to find an approach that consistently delivers risk-adjusted returns that exceed that of a passively managed benchmark. While we

believe that there is no such thing as perfection when it comes toconsistently beating the market, our research indicates that there areindeed methods of investing that have demonstrated the ability to add value, through improved risk-adjusted returns, over prolonged periodsof both bull and bear markets.

This paper will present Momentum Investing as one method to helpinvestors achieve superior risk-adjusted returns across a range of marketenvironments. Both a conceptual example of momentum investing and acompleted investment strategy are presented.

Active vs. Passive Investing

Can you beat the market?

The efficient market hypothesis asserts that it is impossible tooutperform the stock market with less risk. The theory states that all

public and private information is instantaneously priced into stocks at alltimes. Those who adhere to the theory are likely to utilize a buy-and-hold approach comprised of a diverse blend of low cost index funds.Most refer to this type of investing as traditional asset allocation or passive investing.

There is a huge assumption in this hypothesis - Do passive investors perform, over the long haul, at the same level as the benchmark? If not, howdoes this impact the efficient market theory?

Ar e inves to rs rat ional?

A major flaw associated with traditional asset allocation has beendemonstrated time and time again over the course of the last twodecades - investors allow emotion to dictate their investment decisionsat the most inopportune times. Severe market downturns coupled withemotionally driven investors have led the retail investor to dramaticallyunderperform a passively managed benchmark. During times of stock market duress, retail investors exit their positions in the stock marketdue to fear. Once the market conditions improve, they re-enter theequity market, often at higher (worse) prices. While many claim to bepassive investors, the fact of the matter is that very few buy and hold investors actually exist.

Each year, market research firm Dalbar, Inc. conducts a study to comparethe average investors return relative to the broader market. For 2011, theaverage equity fund investor experienced a loss of 5.73% compared to a gainof 2.12% for the S&P 500. The average investor performed 7.85% worsethan the benchmark i.

Theres always a bullmarket somewhere, no

matter what sort of economic conditions

exist. The challenge liesin identifying the sub

sectors within the equityand fixed income markets

that offer the best opportunity for success



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Over the course of the last 20 years, the average equity investor averaged 3.49% annually compared to 7.81% for the S&P 500 ii. To put that into

perspective, a $100,000 initial investment in the benchmark, without anychanges over the test period, resulted in the ending balance being $441,950.The average retail investor, who made changes over the test period, resulted in an ending balance of $186,821, or a difference of $255,129.

Average Investor Performance over past 20 years

Performance Impact

Removing Emotion - The Key to Success

The majority of successful investors are methodical in their approach. Byremoving emotion from the investment process and focusing upon a time-tested rule based methodology, the probability for success increasesexponentially. For the remainder of the paper, we present momentuminvesting as a viable rule based methodology that can be used as thefoundation of a diversified portfolio. We compare a momentum based approach to both a value (buying weakness) and buy-and-hold investingapproach.

Dalbars Quantitative Analysis of Investor

Behavior (QAIB) studyhas been conducted each year since 1994. Their research shows that the

average investor hasdramatically

underperformed a buy-and hold approach over

the last 20 years.

3.49%

7.81%

-4.32%

Avg. Investor Benchmark Difference

$-

$100,000

$200,000

$300,000

$400,000

$500,000

$600,000

1991 1993 1995 1997 1999 2001 2003 2005 2007 2009

Benchmark Average Investor



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Momentum Investing"Perhaps the best known investment paradigm is buy low, sell high.

I believe that more money can be made buying high and selling at even higher prices. I try to buy stocks that have already had good

price moves, that are often making new highs and that have positiverelative strength. These are stocks that are in demand by other investors. What is the risk? Obviously, the risk is that I'm buyingnear the top. But, I would much rather be invested in a stock that isincreasing in price and take the risk that it may begin to declinethan invest in a stock that is already in a decline and try to guesswhen it will turn around."

Richard Driehaus Driehaus Capital Management

Richard Driehaus is known by many as the Father of MomentumInvesting. He currently manages over $10 billion using variations of theapproach. Other early momentum investors include George Soros and William ONeil, the founder of Investors Business Daily. One of Mr.ONeils associates, David Ryan won the U.S. Investing Championship in1985 with a 161% return. He came in second in 1986 with 160% return and followed that up with another first place finish and yet another triple digitreturn ii. When asked how he did it, Ryan replied To sum it up, Im lookingfor the strongest stocks in the market, in terms of both earnings and thetechnical picture (momentum investing) The more disciplined you canget, the better you are going to do in the market.

Momentum Definit ion

The success of momentum investing hinges upon the market phenomenon of trend persistency. Psychology among stock market participants, morespecifically fear and greed, creates a tendency for the strongest performingstock market sectors to continue to outperform over the short-term (3-9months). In other words, some market participants experience fear that theywill miss out on the trend and ultimately invest. Others, who already haveinvested, allow greed to influence their decision to add to their winning

position. Each of these actions further perpetuates the trend. Becausemomentum investing is contrary to what many investors are taught (buylow & sell high) the idea of selling losers and buying winners is difficultfor some investors to do.

Momentum Research

Our studies pertaining to momentum investing over the years have centered

upon our desire to create a robust, retail-oriented alternative to traditionalasset allocation. While outperformance is important, maintaining some levelof diversification in an effort to reduce drawdowns and produce compellingrisk-adjusted returns has been our goal.

When utilized properly, our research indicates that momentum investingmaintains the ability to outperform a passively managed benchmark on arisk-adjusted basis over extended periods of time.

While momentum investing may come in and out of favor, over longer

Research indicates that the investor who follows asystematic approach and removes emotion from theinvestment process has a

higher probability of success than those that do

not.



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periods, research has shown it to be one of the most consistent and reliableforms of investing.

Momentum Strategy Background

While the momentum strategies described below have been tested acrossdifferent mutual fund universes and platforms with favorable results, in this

paper we describe the strategy using Fidelity Sector Funds. There areapproximately 40 sector equity funds and 10 income funds available toinvest in within our designated universe.

Research Overview

We begin our research test on December 31, 1990, and analyze over 20years of data. We assume an initial investment amount of $100,000. Further,no cash additions or withdrawals are made during the test period and nomanagement fees or taxes are deducted.

Momentum Strategy

This momentum strategy evaluates a single variable in order to determine anoptimal allocation: mutual fund momentum. The strategy invests in the sixhighest ranked mutual funds, equally weighted, under the premise that theywill continue to be strong performers for the next period. The rules to thestrategy are outlined below.

Approximately every 45 calendar days:

Step #1: Momentum Algorithm:

Analyze and rank all available mutual funds based on an aggregateview of their 1, 3, 6 and 12 month returns. Our objective is to blend these time frames to come up with an average look back of 4 to 5months.

We then compare this to a common investment approach - value investing(buying weakness). The value system presented invests in the six weakestmutual funds, equally weighted, based on the same ranking algorithm as themomentum system previously described.

Test Results

The equity curve and performance metrics presented below demonstrate the potential of a momentum based investing approach. Performance of themomentum strategy (MOMO1) is superior to that of a value-based approach(VALU1) as well as the benchmark (Vanguard S&P 500 Fund) on both anabsolute and risk-adjusted basis.

Some of the equity sector funds included in our

analysis:

Biotechnology

Consumer Staples

Financial Services

Natural Resources

Utilities

Energy

Construction & Housing

Natural Gas

Transportation

Retailing

Electronics

Gold Automotive

Defense & Aerospace

Health Care

Technology

Banking



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Momentum Strategy Performance

Annual Results Summary

$-

$500,000

$1,000,000

$1,500,000

$2,000,000

$2,500,000

$3,000,000

$3,500,000

$4,000,000

$4,500,000

$5,000,000

S&P 500 Index VALU1 MOMO1

While the momentum approach performed well for the entire test

period, it did so with above averagevolatility. Despite the fact that the

model is still trying to recover from a2011 drawdown, the research

demonstrates just how powerfulmomentum investing can be.



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Momentum Strategy Within Market Environments

Numerous studies have attempted to identify when it is favorable to invest inthe stock market and when it is favorable to be out of the market or on thesidelines. While there are a variety of methods that can be used in this area,there has been research to suggest that investing in the stock market onlywhen it is in a positive trend can reduce risk. A simple way to quantifythis is to only invest in the equity leaders when the stock market is tradingabove an intermediate-term moving average.

This version of the momentum strategy adds another element to the one previously discussed - market environment as a binary strong/weak output. Itevaluates two variables in determining the optimal allocation: marketenvironment and fund momentum. The strategy invests in 3-6 mutual fundsfor a portfolio based on the following.

Approximately every 45 calendar days:

Step #1: Market Environment:

Identify market environment as strong or weak

Step #2: Momentum Algorithm:

Analyze and rank all available mutual funds based on anaggregate view of their 1, 3, 6 and 12 month returns

If the market environment is weak invest in the three highest-ranked income funds.

If the market environment is strong invest in the six highest-ranked equity and income funds.

Once again we compare this to the value investing approach. The valuesystem presented in this example invests in the weakest six mutual funds

based on the same ranking algorithm as the momentum system previouslydescribed.

Test Results

The below equity curve and performance metrics demonstrate the potentialof a momentum based investing approach and incorporating a marketenvironment filter. Performance of the momentum strategy (MOMO2) issuperior to that of a value-based approach (VALU2) as well as the

benchmark on both an absolute and risk-adjusted basis. The addition of themarket environment algorithm improves the performance of the momentumstrategy (MOMO1) on both an absolute and risk-adjusted basis.

Some of the fixed income funds included in our

analysis:

Investment Grade

Short-Term

Ginnie Mae

Money Market

Inflation Protected

Intermediate Government

Intermediate

Mortgage

Government Income



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Momentum Strategy Within Market Environments

Annual Resul ts Summary

The addition of a market environment filter improves both

risk-adjusted and absolute returns of the momentum strategy over the

entire test period. Its interesting tonote, however, that for the first 10

years a momentum approach with nomarket enviornment analysis is

superior. It makes sense to concludethat through secular bull market

enviornments, eliminating the market enviornment filter produces better

returns; it also makes sense toconclude that through secular bear market enviornments the ability to

play defense is essential.

$-

$1,000,000

$2,000,000

$3,000,000

$4,000,000

$5,000,000

$6,000,000

$7,000,000

S&P 500 Index VALU1 VALU2 MOMO1 MOMO2



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Performance Metrics Summary

ConclusionSince the beginning of the stock market, investors- both

professional and amateur alike, have been attempting to beat themarket. Over the years, severe market downturns coupled withemotionally driven decisions has led retail investors to significantlyunderperform. Research shows that during times of stock marketduress, retail investors exit their positions and re-enter the equitymarket as conditions improve, often at higher prices. One suchstudy by Dalbar, Inc. shows that over the past twenty years, theaverage equity investor averaged 3.49% annually compared to7.81% for the S&P 500 1.

In this paper we presented two versions of a rule-based momentuminvesting approach, each of which removes emotion from theinvestment process. Both systems are based upon the market

phenomenon of trend persistency caused by the fear and greed of market participants. As demonstrated, the first momentum system

presented outperforms both a value-based system and benchmark,on an absolute and risk-adjusted basis over the 20+ year test period.While the second, with the addition of a market environmentfilter outperforms a pure momentum system, value-based systemand benchmark on an absolute and risk-adjusted basis over thesame 20+ year period.

Those that subscribe to the efficient market hypothesis will tell youthat it is impossible to outperform the stock market with less risk we disagree. The research presented in this paper can beimplemented across numerous investment products and platforms.Furthermore, the research is simple enough for a retail investor to

understand. Such an understanding should provide investors withthe confidence needed to stick with a strategy when their emotionsmight be telling them to do something else.

Performance Metric MOMO1 VALU1 MOMO2 VALU2 BenchmarkAnnualized Return 18.51% 9.45% 20.63% 10.66% 9.00%Cumulative Return 3978% 618% 5904% 814% 557%Sharpe Ratio 0.77 0.32 1.05 0.66 0.39

Maximum Drawdown (%) 29.0% 61.0% 22.1% 23.5% 51.0%Max. Drawdown Length (Months) 43 73 23 49 74Alpha 10.75% 0.00% 14.78% 5.18% N/ABeta 0.79 1.08 0.46 0.40 N/A

As the performance metricsdemonstrate, using momentum and adjusting exposure within various

market enviornments (shown in bold)roves to be the optimal method. Not only does the approach produce thehighest risk-adjusted returns, but themaximum drawdown, both in length

and size, are superior to other methods.



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About the Authors

Adam Quir ing

Email: [email protected]

Adam is a Principal Partner at Q3 Asset Management. His career started on the floor of theChicago Board Options Exchange in 1999. He has worked for both traditional and alternativeinvestment firms including Munder Capital Management. Adam graduated with a degree in

business from Northern Michigan University. He currently maintains a Series 65 license.

Bradford Giaimo


Brad is a Principal Partner at Q3 Asset Management. His career started on the floor of the NewYork Mercantile Exchange in 1982. From 1984 1986 he worked for Paul Tudor Jones as a

proprietary trader for Tudor Investment Corporation. At the end of 1986 he left Tudor to becomea member of the New York Board of Trade where he spent the next 12 years as a floor trader. Itwas during this time that he developed his affinity for quantitative market analysis. Mr. Giaimo isa graduate of the University of Hartford and maintains a Series 65 license.

Eric Detterman


Eric focuses upon Research and Strategy Development at Q3 Asset Management. He graduated with a BS Economics, with honors from Oakland University. Throughout his career he hasworked in a diverse range of quantitative and information technology (IT) roles. In early 2008 heleft a corporate IT position to focus on developing and running his own quantitative trading

programs. His experience in software development and process re-engineering has helped to build

the structured and repeatable strategy design, development and testing process in place at Q3Asset Management.

About Q3 Asset ManagementEstablished in 2006, Q3 Asset Management is an independent Registered Investment Advisory firm offering adiverse blend of quantitative investment strategies. Our mission is to provide financial advisors and their clientele with an investment approach that maintains the ability to adapt to changing market conditions. We arefirm believers that true diversification lies in combining a strategic blend of non-correlated investment

programs.

Q3 Asset Management is located in Birmingham, Michigan. Our investment advisory services are offered through a variety of providers including Trust Company of America, TD Ameritrade, Fidelity, Rydex,ProFunds and Jefferson National. Additional information on Q3 Asset Management can be found atwww.q3tactical.com .

i,ii Source: Quantitative Analysis of Investor Behavior, 2012 DALBAR, Inc. www.dalbar.com ii Source: Schwager, Jack (1990) Market Wizards.

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Q3AM Momentum White Paper