Aqr Case Report - Momentum Mutual Funds

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1. Compare the UMD factor to other specifications for momentum.

Figure 1 Average returns for momentum strategies

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Basically, the portfolios given in Exhibit 4 are formed and ranked based on the past returns (t-12 to t-2). Momentum strategy suggests that the fund managers should buy the portfolio/portfolios of high ranks, and short sell the portfolio/portfolios of low ranks in order to generate abnormal returns. But does the momentum actually exist? According to Exhibit 4, from 1927 to 2008, the average returns using different specifications for momentum (decile spread, quintile spread, UMD spread and median spread) all record positive outcome, which implied that the momentum did exist throughout the 82-year period. The specific average returns for every decade are shown in the above table. It can be observed from the chart that all these four factors are of similar trends. In particular, median spread portfolio returns are the lowest among four momentum factors with the least standard deviation of only 6.194, while the decile spread momentum has the highest standard deviation of 12.680, which means that trading on the median spread momentum strategy are less risky and meanwhile less profitable than trading on the decile spread momentum strategy.

Some investors took it for granted that momentum strategy would be less effective after it goes public, historical data has already told us that the concern is in fact unnecessary. Take UMD factor’s returns as an example, before the strategy was published in 1993, the average UMD spread portfolio return was 11.099%, only slightly higher than the counterpart of 10.364% after 1993. Therefore, publication of the momentum strategy does not affect its usefulness dramatically.

2. Details of AQR momentum strategy

2.1 How AQR’s retail momentum strategy differ from the traditional approaches

First, the major difference between AQR’s momentum strategy and the traditional momentum approaches is that AQR’s fund would be long-only, while the traditional approaches long and short. Second, the rebalancing period of AQR is different from that of the traditional approaches. Both in the UMD and the strategy followed Jegadeesh and Titman, all the stocks are re-ranked monthly. While the AQR’s strategy re-rank stocks quarterly. Third, traditional momentum approaches don’t specify the range of firms to be selected. For example, UMD ranks all listed stocks. However, AQR’s strategy computed its momentum indexes based on three categories: US stocks with large capitalization, the US stocks with small capitalization and the international stocks with large capitalization.

2.2 Expected return and risks of AQR’s strategy and traditional approaches

Table 1 Adjusting Returns for Risk

Note: The market average return, standard deviation and the risk free rate are respectively 7.64%, 20.62% and 3.76%.