Momentum Strategies: A Mass Review

As a devout mean-reversion trader, I detect Mike Dever's novel majority "Jackass Investing" unexpectedly well-argued in addition to readable.

You see, momentum in addition to mean-reversion traders alive inwards 2 split upwardly universes, in addition to they are oftentimes mutually incomprehensible to each other. Dever, every bit a CTA, inhabits the momentum universe. Example: my favorite functioning measure, the Sharpe ratio, has been brusquely dispatched every bit a bad standard of risk, in addition to drawdown becomes king. But all for skillful reasons: Dever argues that Sharpe ratio measures solely the daily volatility of returns, only disregarded the "black swan" events, which are much amend captured yesteryear the maximum drawdown. I handgrip alongside the writer on this point, only at that spot are other uses of Sharpe ratio: a high Sharpe ratio strategy does signal high statistical significance of the trading strategy, a claim that momentum strategies tin seldom make. I oftentimes scream upwardly of momentum strategies every bit beingness long options: you lot cause got to proceed paying premium until 1 day, you lot brand them all dorsum alongside a dwelling run. But when you lot are backtesting a strategy, how would you lot know that the rare, statistically insignificant, dwelling run was non due to information snooping bias? Unless of course, similar the author, you lot cause got key insights into the traded instruments.

Fundamental insights are inwards fact 1 of the delicious highlights of this book. Dever describes his orangish juice futures strategy using the "marginal cost of production" every bit a key valuation tool. He argues that orangish juice cannot live on sold below this cost, since farmers would cause got no incentive for production otherwise. And he was right: orangish juice futures started to rebound from the 27-year depression of 55 cents/pound inwards May 2004, to almost xc cents/pound inwards September (thanks partly to hurricanes hitting Florida). Dever went long at lxx cents. Oh, how nosotros quantitative traders would beloved to cause got the confidence that such insights inspire!

Of course, I don't handgrip alongside everything written inwards the book. For example, though the writer rightly pointed out that the distribution of returns oftentimes cause got a positive kurtosis, he uses that every bit bear witness of trending behavior. While I handgrip that toll trends tin indeed arrive at positive kurtosis, nosotros tin surely fix mean-reverting toll serial alongside occasional catastrophes that cause got the same kurtosis. To us mean-reversion traders, positive kurtosis is non an invitation to "follow-the-trend", only every bit a alarm sign to detect run a endangerment management measures that protect us from catastrophes. 

Even though momentum strategies inwards full general are inwards a acre of trauma correct directly (more on that later), Dever notwithstanding makes a skillful representative why nosotros should include them every bit piece of occupation of our portfolio of strategies. Comparing the S&P500 index (SPX) alongside the S&P Diversifed Trends Indicator (DTI, a unproblematic trend-following strategies on 24 futures), he finds that the Sharpe ratio (though of course of report he refuses to utilisation that hated term) of the DTI is to a greater extent than than double that of the SPX, alongside solely virtually 1/3 of the maximum drawdown. But earlier you, the reader, decides to bring together the momentum bandwagon, I invite you lot to cause got a aspect at a plot of DTI's values since inception:

S&P DTI index

Since its high watermark inwards 2008/12/5, this representative momentum strategy has been inwards a relentless drawdown. Why? This is due to to a greater extent than or less other well-studied in addition to troubling property of momentum strategies: they ever performed poorly for several years after a fiscal crisis.