DR.CHENJIAZI ZHONG

Traditionally, annualized return volatility is believed to decrease over long periods because of mean reversion. In fact, stocks are more volatile over long periods because of parameter uncertainty. In order to better understand capture the determinants of future outperformance, we have spent great efforts in research from both quantitative and qualitative perspectives.

Time Series Momentum vs. Cross-Sectional Momentum

Time series analysis allows for multiple historical observations of asset classes over time, whereas cross-sectional analysis compares asset classes at one historical moment. A recent experiment reveals that time series momentum returns are extremely strong for commodities, currency pairs, equity indices, and sovereign bonds for backward-looking and holding-period of a year or less. Across these four asset classes, time series momentum returns are significantly positive after being risk-adjusted for their exposures to the market, to the standard Fama–French factors, and to other cross-sectional value and momentum factors.

A formal breakdown of cross-sectional momentum returns into auto-covariance and cross-covariance terms suggests that the former provides all of the returns, with the latter detracting. Time series momentum contains only the auto-covariance, so it outperforms, for sure. Beyond that, it is also more consistent with behavioral explanations of momentum.

About the Methodology

In the time series momentum and cross-sectional momentum study, the researchers regressed time series momentum returns for these four asset classes against ranked cross-sectional momentum returns. They found that 1) spot returns, which are information driven, exhibit momentum, they partially reverse, whereas roll returns, which are hedging-pressure driven, do not show any such reversal; 2) although the cross-sectional momentum coefficient is significant, time series momentum has significantly positive alpha in all formulations; 3) cross-sectional series momentum returns are fully explained by time series momentum, with a negative alpha term.

Instead of solely focusing on numbers, it is also important to note that investors should be intellectually honest about their thesis and rationale for investments:

• Search for confirming views – people tend to be twice as likely to seek information that confirms their beliefs than they are to consider evidence that contradicts them.
• Easily influenced by volatility – if an investment is made without a thorough understanding, it could lead to emotional decision due to the lack of a sound thesis to look past short-term noise and focus on the big picture.
• Lack of conviction – “Long-term investor is one whose holding is currently under water.”
• Loss aversion – investors take more risk because of the “loss aversion,” which is a psychological bias that entails an investor holding a stock in hopes of breaking-even instead of selling and taking a loss.

The factors that drive market returns are demographics, fiscal commitments and adaptability, and the connectedness of global institutions and economies. The primary fundamental forces that drive these factors are:

• New world power order – a regionally centered global game holds many challenges:  people make a poorer performance of government than of almost any other human activity; complex societies are difficult to support and costly to maintain.
• Illiquidity and insolvency – current liquidity crises have spurred massive expansions of central bank balance sheets in the U.S. and Europe; currency devaluations could occur based on inflation expectations, prior to and engendering actual inflation.
• Integration and connectedness – since the populations of less developed regions will be in their peak saving years, the foreign currency that flows to them through trade will be recycled back into the more developed economies as investment. Such capital flows are beneficial for heavily indebted developed countries looking to finance large sovereign debt burdens. Free trade agreements provide a basis for assessing the change in connectedness of countries over time, and the integration and the connectedness provide the potential for economic growth to be an important solution to the problems materializing across the developed world.

Finally, there are some disciplines that need to be integrated with traditional financial tools in order to invest meaningfully:

• Game theory (economic/abundance, threat/bluff, risk tolerance/disinterest, coalition/adaptability) is a critical tool for analyzing the emerging new world power order and the political machinations that will envelop international illiquidity and national insolvency challenges.
• Macroeconomic theory – the issues of illiquidity and insolvency bring to light the importance of a solid grounding in macroeconomic theory.
• Geopolitical science – increased global integration and connectedness demonstrate the importance of geopolitical science into the pricing of assets and resources.

References:

1. Time Series Momentum – Tobias J. Moskowiz, Yao Hua Ooi, and Lasse Heje Pedersen (2011)
2. Dynamic Allocation Strategies, William Blair (March 2012)