What Explains Momentum When It Really Works?, with Pedro Barroso
Abstract: After long being one of the main puzzles in asset pricing, stock momentum has ironically become a case of observational equivalence. It can now be explained by behavioral factors capturing mispricing, the neoclassical-inspired investment q-factors, and by momentum in factors. We note that recent tests subsuming this anomaly are unconditional exercises while the bulk of momentum profits are predictable and occur especially after periods of low momentum volatility. Comparing asset pricing models conditionally, when the strategy actually works, we find the unconditional fit is misleading. The models fit well most of the time but not when the profits are produced. Noticeably, momentum’s conditionality cannot be attributable to its time-varying associations with q-factors or factor momentum. On the other hand, consistent with an underreaction channel, earnings announcement returns and analyst forecast errors both decrease steeply with lagged momentum volatility.Calm Your Portfolio: The Importance of Disciplining Intelligent but Fickle Forecasts in Portfolio Optimization, with Pedro Barroso and Konark Saxena
Abstract: We study portfolio optimization for the top 500 U.S. stocks using their characteristic information. We find that, to outperform value-weighted portfolios while accounting for transaction costs and managing risk, it is crucial to efficiently utilize characteristic information while stabilizing both weights and volatility. We propose and test a portfolio optimization framework that includes turnover penalties, alternative optimized portfolios to the tangency portfolio, and volatility caps. Portfolios incorporating our recommendations yield more stable weights and consistently outperform value-weighted portfolios across various metrics. These results are robust across different covariance and mean estimators, including advanced machine learning and artificial intelligence approaches.Facts, Momentum, and Factor Momentum, with Pedro Barroso
Abstract: Factor momentum recently joined the ongoing debate over the causes of stock momentum. According to this explanation, momentum in well-known “off-the-shelf” factors - or in principal component factors responsible for large commonalities in stock returns - greatly subsumes momentum in individual stocks. We find that neither form of factor momentum can explain any previously proposed momentum driver; conversely, all other drivers combined can subsume both forms of factor momentum. Also, compared to previous drivers, factor momentum does not exhibit superior performance in capturing other momentum-like anomalies. Like the competing models, it cannot explain stock momentum conditionally. Moreover, it cannot explain stock momentum after accounting for transaction costs while these can explain the persistence of factor momentum, especially in less systematic factors.