Dorsey Wright momentum ETFs: simple filter to improve performance

Continuing this series on the Dorsey Wright momentum (or relative strength) ETFs DWAS and PDP:

These funds are designed around the momentum anomaly discussed extensively on this blog.  Fama-French data shows a frictionless annual return greater than 20% for small-cap high-momentum US stocks.

However, there is a another anomaly named “long-term reversal” where poor performers over the past few years (excluding current year) outperform:

Capture8

Next month performance is in inverse order of past 5 year return, excluding current year (i.e. price 13 months ago minus price 60 months ago).

Chen and Kadan showed that double-sorting on both anomalies leads to significantly increased returns:

Capture9

(MQ = momentum quintile, RQ = LT reversal quintile, data covers 1926 to 2006)

Update: note that Chen et. al. use a different measure than Fama-French: price 13 months ago minus price 24 months ago.

Simply by excluding the upper half of long term outperformers, monthly returns are increased significantly.  Monthly excess returns would rise to 1.30% from 1.15% (i.e. increase by 2 percentage points annually).  This filter would be worthy of consideration in the Dorsey-Wright funds.

Essentially, the screen would find stocks with a price history similar to the illustration below, where time zero corresponds to the buy point.  A fund manager could then filter that list by other criteria such as earnings or global macro drivers to satisfy the mandate of the fund.

fig11

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7 thoughts on “Dorsey Wright momentum ETFs: simple filter to improve performance

  1. I would like to discuss hiring you to do a research project for me. Please email me your contact information and a good time to contact you. Once I receive your email, I will send you my contact information

    John

    • Joe, the breakpoint is the median NYSE market equity, so basically the lower half when arranged in order of size:

      The portfolios, which are constructed monthly, are the intersections of 2 portfolios formed on size (market equity, ME) and 3 portfolios formed on prior (2-12) return. The monthly size breakpoint is the median NYSE market equity. The monthly prior (2-12) return breakpoints are the 30th and 70th NYSE percentiles.

      • Thanks! May I also ask what stock screener you use to replicate the study? In Fidelity I cannot screen by price momentum for a custom time frame, only by last 1 or three years. Do you know of one which would allow to screen by price momentum 6 to 1 year ago? -Thanks again. Joe

      • Joe: Ken French does the screening, I am only analyzing the portfolios from his data library. He must run scripts on the CSRP database.

  2. From what I understand Chen, Kadan, & Kose used just 1 year to assess reversal (-13 to -24 months), while you seem to suggest four (-13 to -60). Why the departure?

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