For professional investors only

The momentum factor:

the basics and Robecos solution

White paper | February 2013

By
Willem Jellema, CFA, Portfolio Manager,
Joop Huij, PhD, Quantitative Researcher and
Simon Lansdorp, PhD, Quantitative Researcher

Willem Jellema,
CFA, Portfolio Manager

Joop Huij,
PhD, Quantitative Researcher

Simon Lansdorp,
PhD, Quantitative Researcher

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 Investors increasingly allocate to factor premiums such as size, value, momentum and low volatility
The momentum effect means that stocks that have performed well in the recent past to continue to perform well
The momentum factor has a relatively high premium and provides attractive diversification benefits because of
low correlation with other factors
A conventional momentum strategy takes on high risks and incurs large transaction costs
Robeco Momentum Equities harvests the momentum premium in an efficient way by avoiding unrewarded risks
and limiting transaction costs

Introduction
Factor investing, which advocates looking
beyond traditional asset classifications and
allocating to factor premiums such as size,
value, momentum and low volatility, is taking
ground. Especially since the publication of an
influential report for Norges Bank Investment
Management,1 one of the largest investment
managers in the world, an increasing number
of institutional investors allocates to factor
premiums, while more are interested. At
Robeco, we embrace the concept of factor
investing. Since 2006 Robeco manages
Conservative Equity strategies to capture
the low-volatility premium for equities. At
the beginning of 2012, we introduced Robeco
Conservative Credits as our low-volatility
solution for credit markets. As of August 2012,
we also offer Robeco Momentum Equities
as our solution to efficiently harvest the
momentum factor.
We believe there is a strong case for investors
to allocate to momentum in their factor
portfolios. In this note we will explain why
and we will discuss Robecos approach to
momentum investing. Not only will we explain
the momentum effect and its attractive features
within a factor portfolio context, we will also

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address the challenges related to momentum

investing. We will present the research we have
done into ways of dealing with these challenges
and how we apply them in our Robeco
Momentum Equities fund.

The momentum factor

The momentum effect, first documented by
Jegadeesh and Titman for the US stock market
in 1993,2 is the tendency of stocks to show
persistence in performance. The winner stocks,
or stocks that performed well in the recent
past, on average outperform other stocks in

the subsequent period. Vice versa, loser stocks,

or stocks with poor returns, tend to lag behind
in the following period as well.
The academic literature proposes several
explanations for the momentum effect. Some
argue that the momentum premium is a
compensation for risk.3 Other research identifies
behavioral finance as the source of the momentum
effect.4 As we will discuss later, we find that not all
risks associated with a momentum strategy are
rewarded, because they can be avoided without
giving up the momentum premium.

The momentum effect around the world

Source: mba.tuck.dartmouth.edu/pages/faculty/ken.french. Large cap momentum portfolio returns

from November 1990 to August 2012 (except for the US which starts in January 1927).

Ang, Goetzmann and Schaefer, Evaluation of Active Management of the Norwegian Government Pension Fund Global, Norwegian Ministry of Finance, 2009.
Jegadeesh and Titman, Returns to Buying Winners and Selling Losers: Implications for Stock Market Efficiency, Journal of Finance, 48, 1993.
See, e.g., Chordia and Shivakumar, Momentum, Business Cycle, and Time-varying Expected Returns, Journal of Finance, 57, 2002.
See, e.g., Gutierrez and Pirinsky, Momentum, Reversal, and the Trading Behavior of Institutions, Journal of Financial Markets, 10, 2007.

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The momentum effect is not only present

in the US, but in markets all over the world.5
The effect is shown to withstand the test of
time and to exist even within the most liquid
segment of stocks,6 which is important for
a practical implementation of a momentum
strategy. The economic significance of the
momentum effect for large-cap (as a proxy for
liquid) stocks in different regions is illustrated
in the figure below. Clearly, the recent winners
keep on outperforming the market in each of
the different regions, while the losers lag
the market.

The momentum factor versus other

factor premiums
The momentum factor is one of the strongest
factors known to exist in equity markets around
the world and is used in many balanced quant
models. Momentum has a high factor premium
and as such can be an important source of
return for a factor portfolio. This is illustrated

in the figure below on the left, which plots

the returns of the market and a number of
factors for US equities. Together with value, the
momentum factor has the highest return, well
above the market. In addition, the momentum
premium exhibits a low correlation with lowrisk and value premiums. The figure below on
the right shows that momentum is uncorrelated
with the size, value and low-volatility factor
premiums for US stocks. As a result, the
diversification potential of momentum in
a factor portfolio is expected to be significant.
Because of these two reasons, a momentum
fund can be of great benefit to a portfolio that
allocates to factor premiums.7

The challenges of momentum

investing: unrewarded risk and
turnover
Despite the attractive features of the
momentum factor mentioned above, hardly any
investment funds aim to systematically harvest

US factor premiums vs correlations

Source: David Blitz, Strategic Allocation to Premiums in the Equity Market, Journal of Index Investing, 2012.
Correlations are calculated in excess of the market premium. The sample period is from July 1963 to December 2009.

the momentum premium. As momentum

both provides investors an attractive premium
in the long run and diversifies strongly with
other factor premiums, the question arises why
so few funds explicitly target the momentum
premium. We believe the answer is that
investors face two concerns, or challenges,
when they allocate towards momentum: the
risk and the turnover of a momentum strategy.
A successful momentum strategy needs to be
able to deal with these challenges.
To explain how a generic momentum strategy,
which selects stocks with the highest past
returns, can take on large risks and incur high
transactions costs, let us have a look at how this
strategy works in a bull market. In this upward
trending market, the momentum portfolio
will mostly contain high-beta stocks, because
these stocks earn the highest returns in a
bullish environment. This is how momentum
earns its premium, because as long as the
market continues to rise, the high beta stocks
outperform the market. However, when there
is a market reversal, the high-beta stocks will
be the biggest losers, while low-beta stocks
become the new winners. The portfolio incurs
large losses on the high-beta stocks, explaining
the riskiness of the strategy. Second, the
momentum strategy replaces the high-beta
stocks with their low-beta counterparts, selling
struggling stocks into a down market, which
explains the transaction costs.
In general, a generic or nave momentum
strategy mostly profits from trends, like
the trend in the market described above, and
in its wake ends up with stocks geared towards

See, e.g., Rouwenhorst, International Momentum Strategies, Journal of Finance, 53, 1998, for evidence on the existence of the momentum effect in European markets,
and Rouwenhorst, Local Return Factors and Turnover in Emerging Stock Markets, Journal of Finance, 54, 1999, for evidence of the momentum effect in emerging markets.
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See, e.g., Fama and French, Dissecting Anomalies, Journal of Finance, 63, 2008.
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For more information on factor investing, we refer to our note by David Blitz, Joop Huij, Simon Lansdorp and Pim van Vliet, Efficient factor-investing strategies, of February 2013.
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these trends. However, when current trends

falter and new ones emerge, this can result
in significant drawdowns for the strategy,
accompanied by a large turnover as the
strategy shifts to a new trend. Hence we think
the returns from these dynamic exposures
to trends, or styles, are elusive, because
they result in large risks for the strategy.
We believe these risks are unrewarded,
because our momentum strategy can earn
a similar momentum premium without the
accompanying risks.

Research insights: how to deal

with the challenges of momentum
investing
To build a successful momentum fund,
the challenges of the large and unrewarded
risks and high transaction costs need to be
addressed. Over time, Robeco has researched
and developed solutions for these issues.
First, our research shows that eliminating

dynamic factor exposures results in similar

(gross) momentum returns, but at risk levels
half that of generic momentum strategies.8
This is achieved by selecting stocks not on their
past total returns, but by using their residual
returns, as explained in the box below. Robeco
employs this residualization technique to
remove the unrewarded risk of a momentum
strategy.
Other research by Robeco shows that
the use of smart trading rules in investment
strategies results in a much lower turnover
than the application of nave trading
algorithms, without the loss of gross
performance. As a result, net profits increase.9
Robeco achieves this turnover reduction with
its proprietary portfolio construction process,
which is applied across its whole quant equity
product range. We apply both these research
findings in Robeco Momentum Equities
to capture more of the gross momentum
premium at lower risk.

Robeco Momentum Equities:

the opportunity to achieve higher
net returns at lower risk
Momentum is the missing ingredient for many
factor investors. Having the research and
experience to avoid the pitfalls of momentum
investing, Robeco now offers Robeco
Momentum Equities. This momentum solution
combines the proven insights acquired from
and published in academic literature with
the dedicated research of Robecos Quantitative
Research department. A fully committed
Quantitative Equity team manages the fund.
The figure left shows the added value of
Robeco Momentum Equities. It is possible to
earn the momentum premium with a generic
momentum strategy, but only at a considerable
higher risk. Also, the upside is limited, because
a large part of the premium is consumed
by transaction costs due to high turnover.
Robecos residualization technique eliminates
unrewarded risks, while our proprietary
portfolio construction process controls turnover.

Robecos residualization technique

Residualization means using residual returns
instead of total returns. Of the two stocks in
the graph opposite, stock B has the highest
return. However, the return on B is in line with
its expected return given its market sensitivity
(beta) of 2, while stock A earns a 5% excess
return after correcting for the market. This
5% is the so-called stock-specific or residual
return, because it remains after correcting for
the market-expected return.

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Because residual momentum selects stocks

with the highest stock specific returns, which
are by definition unrelated to the stocks
betas, beta tilts in the resulting portfolio are
eliminated. Without this unrewarded risk, the
returns of the portfolio are much less sensitive
to market and other trend reversals. The result
is a similar return pattern as that of a generic
momentum strategy, but at much lower risk.

David Blitz, Joop Huij and Martin Martens, Residual Momentum, Journal of Empirical Finance, 18, 2011.
De Groot, Huij and Zhou, Another look at trading costs and short-term reversal profits, Journal of Banking and Finance, 36, 2012

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The result is a momentum fund that, unlike

a conventional momentum strategy, preserves
most of the gross momentum premium at
a considerably better risk profile. Robeco
Momentum Equities enables investors to
efficiently harvest the momentum premium.

Conclusion
Institutional investors are increasingly
allocating strategically towards factor
premiums. To meet this demand, Robeco
introduced Robeco Momentum Equities
in August 2012. The momentum factor is
attractive from a factor investing point of view
as it offers investors a potentially high premium
and attractive diversification opportunities.
The Robeco approach to momentum investing
is designed to capture the momentum
premium in an optimal manner by avoiding
unrewarded risks and boosting returns by
limiting transaction costs.

For more information on factor investing or

Robeco active quant solutions please contact
your local client relations manager or go to
www.robeco.com/quant

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Contact
Robeco (Headquarters)
P.O. Box 973
3000 AZ Rotterdam
The Netherlands
www.robeco.com/quant

Important information
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