1. What is a momentum investment strategy?
Momentum is the phenomenon that stocks which have performed well in the past will continue to perform well in the future, and that stocks which have performed poorly will continue to perform poorly. Therefore a momentum investment strategy is to invest in short term portfolios that have high returns in the past, and to short those with low returns over the same period.
2. Analyze these portfolios.
By analyzing monthly returns of all 10 portfolios from 1927-2012 and 2000-2012, we can see that there is a general pattern that stocks with higher momentum have higher return, which confirms the momentum strategy. The average return of stocks with high minus low momentum is a little lower than that…show more content… We could see that, the P-values for the Four-Factor Model are larger than 0.025, so we cannot reject the null hypothesis. However, the P-values for the Three-Factor Model are all smaller than 0.025, so we can reject the null hypothesis. The test of significance level confirms that the intercept of the Four-Factor Model is almost zero, implying the model holds well with the data we get.
(Results are shown in Exhibit B-I)
4. Is this an appropriate strategy for retail mutual fund investors?
Yes, this is, but only to some extent.
It’s undeniable that this strategy raises much profit. However, at the same time, higher risks also come as a companion. First, mutual funds were legally limited in short positions and leverage. Since academic research on the momentum effect usually consider both the outperformance of winners and the underperformance of losers, it’s not convenient for mutual fund to make comparison with other hedge funds who adopt the same strategies. And academic research results cannot be totally applied to their strategies. So for investors, it’s not easy to estimate risks.
Many other challenges will increase risks for mutual funds to employ such a strategy. To avoid repetition, these challenges will be illustrated in Question Six. One of these challenges is actually a sword with two sides—that is the open-end feature of mutual funds.
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