Combining Value and Momentum in Stock Selection and Market Timing

Finanza Operativa di Finanza Operativa 26 Agosto 2015 | 13:00

A cura di Wesley R. Gray, Alpha Architect
Recently, we wrote two posts about how to combine Value and Momentum for stock selection purposes (Part 1 and Part 2). We followed this piece with a post on combining value and momentum for market timing purposes.
In this post, we review the use of combined Value and Momentum for both stock selection and market timing.
First, let’s examine the combination of Value and Momentum in stock selection. A concept that has been around for many years.

Setting Up a Value and Momentum Portfolio

First, let’s set up the experiment. We will examine all firms above the NYSE 40th percentile for market-cap (currently around $1.8 billion) to avoid weird empirical effects associated with micro/small cap stocks. We will form the portfolios at a monthly frequency with a 3-month holding period — so we use overlapping portfolios, a la Jagadeesh and Titman (1993). We focus on the following 2 variables:

  1. Momentum = Rank firms on three momentum variables: 3-month, 6-month, and 12-month momentum. The average of the 3 ranks is the “momentum” rank.
  2. Value = Rank firms on three value variables: EBIT/TEV, Book-to-Market (B/M), and E/P (inverse of P/E). The average of the 3 ranks is the “value” rank.

Every month, we select the top 100 Value stocks and the top 100 Momentum stocks (and hold them for 3 months). We then equal-weight the holdings.

  1. Value and Mom EW (net) = Top 100 Value firms and Top 100 Momentum firms formed monthly and held for 3 months. Portfolio is equal-weighted. Returns are net of a 1.00% annual management fee and 2.00% annual transaction costs.
  2. SP500 = S&P 500 Total return
  3. LTR = Total Return to Merrill Lynch 7-10 year Government Bond Index
  4. RF = Total Return to Risk-Free Rate (U.S. T-Bills).

Results are net of a 1.00% annual management fee and 2.00% annual transaction costs. Index returns (S&P 500, LTR, and RF) are gross of any fees or transaction costs.  All returns are total returns and include the reinvestment of distributions (e.g., dividends). Indexes are unmanaged, do not reflect management or trading fees, and one cannot invest directly in an index.
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