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Accounting and Finance 50 (2010) 941965

Price momentum in the New Zealand stock market:


a proper accounting for transactions costs and risk*
Sam Tretheweya, Timothy Falcon Crackb
a
PricewaterhouseCoopers, Auckland, New Zealand
Department of Finance and Quantitative Analysis, University of Otago, Dunedin, New Zealand

Abstract
We test for recently reported momentum prots in New Zealand using a practitioner technique that we have not yet seen in the academic literature. This technique simultaneously weighs returns, risk and transactions costs at each
portfolio rebalance, rather than blindly chasing returns and then accounting for
risk and transactions costs after the fact. We reverse the ndings of the earlier literature because our gross prots are more than fully consumed once transactions
costs are properly accounted for. Although we focus on momentum trading in
New Zealand, our practitioner technique is broadly applicable to investigations
of trading anomalies.
Key words: Price momentum; New Zealand; Price impact; Market eciency;
Equity trading
JEL classication: G11, G14
doi: 10.1111/j.1467-629X.2010.00355.x

1. Introduction
We test for recently reported prots from price momentum trading strategies
in the New Zealand stock market (Gunasekarage and Kot, 2007; Stork, 2008). A
particular strength of the paper is the use of a practitioner technique for optimal
portfolio rebalancing subject to risk and transactions costs; we have not seen this
technique used before in the academic literature. Our simplest unconstrained

* The opinions expressed in this paper are those of the authors and do not necessarily
represent those of PricewaterhouseCoopers. We thank Simon Benninga, Robin Grieves,
an anonymous asset manager working for a bulge bracket investment bank and an
anonymous referee for helpful comments. Any errors are ours.
Received 18 December 2009; accepted 2 March 2010 by Robert Fa (Editor).
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momentum portfolio generates gross returns of 185 basis points (bps) per month
over the July 1992 to September 2006 period in line with earlier literature. This
compares very favourably with an NZSE40/NZX50 (i.e. New Zealand Stock
Exchange) benchmark return of only 78 bps per month over the same period.
After accounting for transactions costs, risk and other practical considerations,
however, our realized net return falls to only 52 bps per month more than erasing the prots.
The paper proceeds as follows. Section 2 provides a review of selected literature on price momentum. Section 3 discusses the data and method. Section 4
presents our empirical results. Section 5 concludes.
2. Literature review
2.1. The price momentum anomaly
Levy (1967) concludes that superior prots can be achieved by investing in
securities which have historically been relatively strong in price movement.
Jegadeesh and Titman (1993) demonstrate that strategies that buy past winner
stocks and sell past loser stocks generate signicant excess returns. Jegadeesh
and Titman measure past performance over the prior three to 12 months and
allow for subsequent holding periods of three to 12 months. Price momentum of
this form has now been found by researchers in most markets: Rouwenhorst
(1998) reports signicant momentum eects in 11 out of 12 European countries
(Sweden is the exception); Leippold and Lohre (2008) report signicant momentum eects in the US and 14 out of 16 European countries (Ireland and Austria
are exceptions); Chui et al. (2000) report signicant momentum eects in seven
out of eight Asian countries (Japan is the exception); Hurn and Pavlov (2003),
Demir et al. (2004) and Stork (2008) report momentum prots in Australia; and
Gunasekarage and Kot (2007) and Stork (2008) report momentum prots in
New Zealand.
Fama and French (1996) suggest that momentum prots may be due to
data snooping. Jegadeesh and Titman (2001) respond to this with further
out-of-sample evidence, dismissing the Fama and French data snooping argument. Fama and French (1996) argue that, although many of the CAPM anomalies can be explained by their three-factor model, the momentum prots of
Jegadeesh and Titman (1993) are an exception. Fama and French (1996) suggest
that investors underreaction to recent news produces momentum eects, but
their overreaction to less-recent news causes a longer-term reversal. Daniel et al.
(1998) suggest that investors are overcondent about their own abilities and the
accuracy of their private information and that this leads them to push up the
prices of past winners and push down the prices of past losers. Barberis et al.
(1998) suggest sentiment-driven explanations for underreaction and momentum
prots. Hong and Stein (1999) assume that agents are bounded rational: They
are unbiased in their evaluation of information, but they evaluate only partial
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information, ignoring the rest. With heterogeneous agents and slow diusion of
information through the economy, this leads to underreaction in the short term.
Hong et al. (2000) follow up and conclude that this underreaction is especially
noticeable for negative news, and that momentum prots are stronger in small
stocks and stocks with low analyst coverage. Grinblatt and Moskowitz (2004)
nd that being a consistent winner can double the subsequent return associated
with being in the top momentum decile. Grinblatt and Han (2005) suggest that
the disposition eect (Shefrin and Statman, 1985) could be driving momentum
prots, because selling winners too soon and delaying the sale of losers would
generate price underreaction consistent with momentum. Sadka (2006) nds that
part of the return from momentum trading is compensation for bearing liquidity
risk. Given this brief review, it is fair to say that momentum prots are both
widely recognized and dicult to explain.
In New Zealand, two recent studies identify a strong price momentum eect
(Gunasekarage and Kot, 2007; Stork, 2008). Stork (2008) reports momentum
prots in New Zealand, but he focuses on very concentrated large capitalization
portfolios that are not suitable for institutional asset managers and he does not
account for transactions costs. Gunasekarage and Kot (2007) look at the performance of portfolios formed on the basis of recent three- to 12-month formation
periods. They form three equally weighted portfolios: relative winners, a middle
group and relative losers. They then look at subsequent performance of these
portfolios over three- to 12-month holding periods. They report momentum
strategy outperformance of an NZX index by 12.63 per cent per annum before
transactions costs and 8.80 per cent per annum after transactions costs (Gunasekarage and Kot, 2007, p. 114). They subtract only an arbitrary slice (one-fth)
of gross returns as an ad hoc transactions cost and do not account for actual
spreads or price impact. We argue below that our method is a signicant
advance on Gunasekarage and Kot (2007) and Stork (2008).
3. Data and method
3.1. Data
Our trading strategy uses monthly rebalancing of a portfolio of individual
New Zealand stocks, but some parts of the implementation require daily data.
We use securities that are members of the NZSE40 Capital Index and its replacement, the NZX50 Free Float Gross Index. Index membership, index member
weights and closing prices are obtained on a daily basis from the NZX for the
NZSE40 from June 1991 to March 2004 and for the NZX50 from March 2003
to September 2006. Further daily data from the New Zealand Stock Exchange
Database at the University of Otago are collected to identify bid-ask spreads,
dividend and stock split price adjustments and sector classications. Data are
cross-checked using Yahoo! Finance and the Otago University Bloomberg

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Terminal. The New Zealand Government three-month Treasury bill yield is used
as the risk-free rate of return.
Table 1 provides descriptive statistics for the stocks in the benchmark portfolio. Comparing 2006 with 1991, we see that liquidity has steadily improved over
the time series: The average market capitalization has roughly doubled; average
daily dollar turnover has more than tripled; and average relative spreads have
roughly halved.
Although not shown in Table 1, the corresponding time series improvement
in liquidity is even more dramatic for the median stock in each of the less
liquid turnover quartiles. Even so, signicant dierences in liquidity remain in
the cross-section: For example, by the end of the sample, the median stock in
the least liquid turnover quartile still has one-ninth the market capitalization,
two times the relative spread, and one twenty-sixth the daily dollar turnover of
the median stock in the most liquid turnover quartile. Any na ve momentum
trading strategy that fails to account for these cross-sectional dierences in
liquidity will bias us towards overly optimistic prots because, as we shall see,
it is the less liquid stocks with higher transactions costs that possess the most
attractive momentum characteristics. Sections 3.3 and 3.4 discuss how our
momentum strategy accounts properly for these liquidity and transactions
costs issues.
3.2. The benchmark portfolio
The performance of our momentum portfolio is measured against either the
NZSE40 or NZX50, depending on the time period. The NZSE40 Capital Index
consisted of the 40 largest publicly traded companies in NZ. All listed securities
from these companies were included in the index; therefore, the index regularly
had more than 40 constituents. Without loss of generality, we refer to the index
members as stocks because the non-stock index members (e.g. warrants and
convertible notes) were of very small capitalization. The NZSE40 was discontinued in March 2004, and the NZX50 was introduced. At the end of the NZSE40
period, we expand our portfolios universe of benchmark stocks to the NZX50.
The NZX50 comprises the 50 largest companies listed issues, subject to liquidity constraints. As of 18 November 2009, the 112 members of the NZSE All
Share had a total market capitalization of NZD46.1 billion, whereas the NZX50
securities had a total market capitalization of just over two-thirds this, at
NZD32.7 billion (Bloomberg Terminal, 2009).
To simplify various technical dierences in construction, we use the ocial
index weights obtained from the NZX for each index, but we record the dollar
growth in the benchmark portfolio using the same split- and dividend-adjusted
database returns that we use to calculate dollar growth in our active portfolios.
This creates a level playing eld for the competition between the benchmark and
the active portfolio. Our index growth is, therefore, slightly dierent from that
reported ocially by the NZX.
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1991

1992

1993

1994

Panel A: No. of rms


Mean*
n/a
46
48
49
Panel B: Monthly stock returns (%)
Mean
2.65
1.65
2.44 )2.23
Median
1.62
0.00
0.18 )1.80
Standard
12.36 10.99 15.28 17.23
Deviation
Lower Quartile )3.17 )3.76 )3.49 )6.71
Upper Quartile
8.49
7.65
7.37
3.00
Panel C: Market capitalization ($NZD million)
Mean
614
629
728
909
Median
162
172
218
310
Standard
1208
1182
1476
1796
Deviation
Lower Quartile 64
85
103
184
Upper Quartile 431
396
483
715
Panel D: Turnover ($NZD thousand traded per day)
Mean
687
657
1185
1233
Median
85
144
249
234
Standard
1549
1108
2629
2782
Deviation
Lower Quartile 30
54
105
107
Upper Quartile 390
547
721
571

Year

Table 1
Sample descriptive statistics

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942
353
1933
182
841
1024
273
2178
123
633

171
728
1351
222
4194
94
574

)2.21
4.43

)2.20
4.57
948
302
1935

0.98
0.46
7.35

51

1996

0.89
0.80
8.05

47

1995

125
625

1152
259
2836

199
917

966
387
1997

146
1203

2091
363
6047

226
758

884
395
2023

)6.21
6.20

)0.01
0.00
12.32

)0.65
0.00
8.85
)4.43
4.00

52

1998

52

1997

143
1886

2101
501
6137

235
905

938
516
2075

)3.90
3.86

0.23
0.00
9.40

52

1999

89
1547

2006
458
5991

228
880

898
512
1836

)4.73
4.40

)0.16
0.00
10.17

52

2000

159
1520

1851
514
5233

210
1010

864
507
1402

)2.43
4.66

0.38
0.82
10.23

50

2001

157
1457

1660
479
5864

220
1059

942
517
1446

)3.89
3.66

0.21
0.00
12.01

45

2002

162
1536

1638
519
4508

184
967

839
387
1378

)1.68
5.81

1.84
1.75
9.48

46

2003

182
1366

1906
490
5934

217
1418

1251
447
1957

)0.97
4.63

1.75
1.60
7.58

51

2004

231
1482

2066
556
6320

289
1769

1296
536
1847

)2.97
3.84

0.14
0.00
7.15

51

2005

184
1698

2502
520
9386

291
2024

1305
593
1607

)2.83
4.17

1.24
0.47
6.16

51

2006

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1991

1992

1993

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1.60
1.07
2.06
0.65
1.72

0.70
1.92

1995

1.73
1.17
2.05

1994

0.68
1.57

1.52
0.99
1.94

1996

0.69
1.68

1.58
1.06
2.19

1997

0.85
2.37

2.07
1.21
2.58

1998

0.57
1.83

1.55
0.96
2.14

1999

0.63
2.30

1.91
1.12
2.60

2000

0.56
1.61

1.50
0.91
2.26

2001

0.51
1.46

1.33
0.87
1.91

2002

0.55
1.35

1.43
0.83
2.87

2003

0.44
1.12

0.91
0.68
0.89

2004

0.46
1.09

0.95
0.77
0.91

2005

0.48
1.21

1.05
0.80
0.91

2006

*The mean number of rms represents the yearly average number of rms that were constituents of the NZSE40 or NZX50 and were therefore part of the
momentum portfolio. No momentum portfolios were formed in 1991; these data were used only to construct a historical variance covariance matrix. Panels
C, D and E use a pooled sample where each stocks data are observed on the rst trading day of the month (when the portfolio rebalance takes place), with
the turnover observation being the 40-day moving average used in the price impact calculation.

Panel E: Relative Bid-Ask Spread (%)


Mean
2.33
2.04
1.47
Median
1.53
1.41
1.12
Standard
2.55
2.71
1.26
Deviation
Lower Quartile
0.87
0.76
0.73
Upper Quartile
2.60
2.06
1.71

Year

Table 1 (continued)

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3.3. Price momentum portfolio construction


We execute a quantitative active equity alpha optimization, but with only one
signal: price momentum. This widely used practitioner technique is described in
detail in the practitioner book by Grinold and Kahn (2000a).1 A similar technique appears in Chincarini and Kim (2006, Chapter 9). We begin by constructing ex-ante alphas (also called signals) for each stock, each month using a
series of steps involving scaling and neutralization of raw alphas. The raw alphas
are measures of relative strength. In our case, our raw alphas are simply the log
of the ratio of price one month ago to price seven months ago. That is, they are
six-month log price relatives (or six-month formation period returns) calculated
using a one-month gap. The six-month period is consistent with most prior literature; the one-month gap is included to reduce the impact on prots of possible
short-term price reversals not caused by bid-ask bounce (we use mid-spread
prices). The literature suggests there was a short-term reversal in New Zealand
stocks at the weekly horizon in early data (Bowman and Iverson, 1998, using
19671986 data), but that it was absent at that horizon in later data (Boebel and
Carson, 2001, using 19911999 data).
These alphas are built to be benchmark neutral. In other words, holding the
benchmark exposes you to no ex-ante alpha and no active bets, but actively chasing these alphas goes hand-in-hand with actively stepping away from the benchmark. We then run an optimization routine each month to rebalance our
portfolio weights (the choice variables) by tilting them towards positive ex-ante
alphas and away from negative ex-ante alphas. We retard this alpha chasing by
including a penalty in our objective function that quanties the exposure to
active risk associated with actively stepping away from the benchmark. This
active risk is moderated using a client risk aversion coecient. We also include
penalties in our objective function for the transactions costs incurred by chasing
alpha (the objective function appears below in equation (1)). Our transactions
costs include the explicit cost associated with buying stocks at the ask and selling
them at the bid and also the implicit price impact incurred when we need to
walk up or down the centralized limit order book (CLOB) to ll a trade
thereby pushing prices against us (see Section 3.4, for details of our model of
price impact).
Although addressing the same question and using similar data, our approach
is in stark contrast to the approach of Gunasekarage and Kot (2007). They form
equally weighted long-short portfolios of winners and losers and then ex-post
use an ad hoc estimate of transactions costs. We, however, form optimally
1

An extended version of this paper is available from the authors upon request. It contains
a deeper discussion of the optimization and its constraints, the steps in the alpha construction, the variance-covariance matrix estimation, and the results. It also contains an explicit decomposition and attribution of momentum prots to industry and stock-specic
factors (the rst such for New Zealand).
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weighted portfolios, allow realistic underweighting that avoids shorting and use
realistic transactions costs using actual spreads and a practitioner model of price
impact.
Our approach also contrasts with Korajczyk and Sadka (2004), who use US
stocks. They form equal- or value-weighted portfolios of recent winners and then
account ex-post for the transactions costs needed to rebalance the portfolios each
month. They subsequently compute Sharpe ratios and (Jensen alpha type)
abnormal returns relative to the Fama-French three-factor model.
Although relatively standard, the Gunasekarage and Kot (2007) and
Korajczyk and Sadka (2004) techniques just described are both na ve implementations of an active trading strategy. Practitioners do not blindly chase anticipated returns and then passively account ex-post for the transactions costs and
risk; doing so is sub-optimal. Rather, practitioners weigh all three simultaneously: A portfolio manager may, for example, avoid overweighting a small
capitalization stock that has attractive momentum characteristics if it has high
transactions costs or unfavourable risk characteristics. Korajczyk and Sadka do
attempt to address this deciency by also using liquidity conscious portfolios
with weights that are related to the liquidity of the stock (Korajczyk and Sadka,
2004, pp. 1054, 1075), but they acknowledge that this approach to portfolio formation is optimal only under fairly restrictive conditions (Korajczyk and Sadka,
2004, p. 1054).
Like most quantitative active equity strategies, we try to avoid benchmark timing2 by constraining the ex-ante portfolio beta each month to equal 1 (in practice, we are rebalancing only once a month, so we incur some unintended
benchmark timing as the beta slips away from 1; we account for this in our performance measurement). We also constrain portfolio turnover each month, limit
the size of the active bets in any stock and require the portfolio to be fully
invested in equities. For the relatively unconstrained strategies, we allow short
selling, but ultimately our feasible strategies are all long only.
Korajczyk and Sadka choose to use long-only portfolios of winners. They
argue that this avoids the asymmetric costs associated with the short side of a
long-short strategy (Korajczyk and Sadka, 2004, p. 1045). Many other researchers (e.g. Chen et al., 2002; Gunasekarage and Kot, 2007) use long-short arbitrage
strategies. All these papers, however, overlook our tilts approach, where a passive benchmark fund is actively tilted towards over- and underweights, but without breaching the long-only constraint, and where the optimization takes care of
the transactions costs. Although not a true long-short fund, and although the
long-only constraint may carry a considerable impact (Grinold and Kahn,
2000a, Chapter 15; Grinold and Kahn, 2000b), our resulting long-only
2

Benchmark neutrality also reduces the likelihood that abnormal returns are generated
by any rm characteristics common to the rms in this small market. This is because, by
construction, the overweight/underweight nature of the active positions reduces exposure
to common rm characteristics.
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implementations allow consideration of both winners and losers and look like
standard institutional practice for a quantitative fund.
The choice variables in the optimization are the vector hP of holdings in the
portfolio of stocks that are members of the benchmark. The optimization is a
maximization of a value added (VA) objective function (Grinold and Kahn,
2000a, p. 119) modied for transactions costs. The objective function has the following form:
VA aP  k  x2P  TC

where aP hP 0 aP is the portfolio ex-ante alpha calculated as the inner product


of the portfolio holdings vector and the vector aP of ex-ante alphas for the individual stocks; k is the client risk aversion coecient; x2P  r2P  r2B
hP 0 VhP -hB 0 VhB is the forecast active risk of the portfolio (where B denotes
benchmark), where V is a variance-covariance matrix of returns; and TC is the
estimated transactions costs (including both actual spreads and estimated price
impact) associated with rebalancing the portfolio. Everything in this objective
function is scaled to be in annual return terms (see Section 3.4).
The portfolio is assumed to be launched at the end of June 1992, with benchmark weights (as if an active manager had just taken over a passive fund) and
with an initial investment ranging from $1 in the relatively unconstrained case
up to $150 million. At the end of each subsequent month, we examine our
existing holdings, and we rebalance by running the optimization to chase the
just-calculated ex-ante alphas by choosing new portfolio weights subject to
the above-mentioned penalties and constraints. We calculate gross returns over
the following month, calculate the new end-of-month dollar balance of the fund
and then we recalculate the ex-ante alphas and rebalance again (in all, we rebalance 171 times over our sample period). For each strategy, monthly turnover
was reassuringly credible and in line with our intuition (averages are reported
later in the paper). All strategies are self-nancing; no new money enters the
portfolios. For each gross return simulation, we also perform a separate net
return simulation, where monthly transactions costs are subtracted from the
gross return before calculating the new end-of-month dollar balance of the fund.
At each step, we ensure that all information used for the optimization was available to a portfolio manager at that date. When stocks enter or exit the index, we
temporarily increase the turnover allowance (as a function of the index weight of
the stock that is entering or exiting) to allow the manager to trade into or out of
the position quickly without breaching the turnover constraint. We run the
momentum trading strategy using dierent fund sizes, dierent ex-ante alpha
formation periods, with and without the one-month gap, dierent client risk
aversion coecients, dierent allowances for turnover, dierent allowances for
active weight and with and without short selling. The results are discussed in
Section 4, below.
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3.4. Measurement of transactions costs


Our optimization uses a transactions cost penalty in the objective function
given by TC = 12 hP 0 (RS + PI) calculated as 12 times the inner product of
the portfolio holdings vector hP and the sum of the vectors RS and PI, which are
described below. In practice, fund managers using this technique rebalance more
frequently than monthly, but otherwise our model of transactions costs is used
by practitioners in essentially the same way that we use it here (Grinold and
Kahn, 2000a).
The terms RS and PI are vectors whose elements contain the relative spread,
RSi, and price impact, PIi, functions for each stock i. These stock-specic
functions are estimated as follows (Grinold and Kahn, 2000a, p. 452):

RSi




1  
ask  bid
 h i;t  hi;t  
2
bid ask=2

s
volumetrade
PIi
 rdaily
volumedaily

where h*i,t is the new optimal portfolio holding of stock i at time t, and hi,t is the
existing holding of stock i at time t immediately before the rebalance, bid and
ask represent the current bid and ask prices for stock i (subscript suppressed),
volumetrade denotes the number of shares required to be traded to reach the new
portfolio holding of stock i, volumedaily represents the average daily volume of
stock i for the past 40 trading days (split adjusted) and rdaily is the past 250-day
standard deviation of daily returns to stock i (subscript suppressed on the righthand side of equation (3)). To avoid confusion, note that hi,t, the existing holding
in stock i just prior to the rebalance, is what h*i,t)1 (the most recent rebalanced
optimal holding) has evolved into over the months time period t)1 to t.
Korajczyk and Sadka (2004) calibrate their price impact models explicitly
using US TAQ data. Without intraday data we have instead used, in equation
(3), an implicit scaling based on the traders rule of thumb that it costs approximately one days volatility to trade one days volume (Grinold and Kahn, 2000a,
p. 452). Note that Korajczyk and Sadka use academic models of price impact
(e.g. Glosten and Harris, 1988; Breen et al., 2002), whereas we use a model of
price impact taken directly from the practitioner literature (Grinold and Kahn,
2000a, p. 452).
Like Glosten and Harris (1988), our model of transactions costs for a given
stock is composed of a cost that is xed as a function of volume traded by the
strategy (i.e. the relative spread) and a cost that is a variable function of volume
traded by the strategy (i.e. the price impact). Equation (3) says that we are
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modelling the percentage price impact (i.e. as a percentage of initial stock price)
as a square root function of the number of shares traded by the strategy (in that
stock during that month). This square root form has its foundation in Barra
research that analysed Loeb (1983) and found the results consistent with a
square root pattern (see Grinold and Kahn, 2000a, p. 452). This square root
form is clearly a concave functional form, and it gives immediately a concave
functional form for percentage price impact as a function of dollar volume of the
strategy in that stock.
Loeb (1983), Glosten and Harris (1988), Hausman et al. (1992), Keim and
Madhavan (1996) and Breen et al. (2002) all present theoretical models and/or
empirical results that are consistent with a percentage price impact function that
is, like ours, concave when price impact as a percentage (of original price or of
portfolio value) is expressed in terms of dollar volume. Hasbrouck (1991) presents a price impact model but the functional form for percentage price impact
as a function of dollar volume is not clear.
Although concave when expressed as percentage price impact as a function of
dollar volume, if we multiply both sides of (3) by dollar volume, to look at total
absolute price impact cost (in dollars) as a function of dollar volume, the resulting convex functional form involves dollar volume to the power of 3/2 (Grinold
and Kahn, 2000a, p. 452).
Finally, the annualized transactions cost is the cost of a trade divided by the
rebalance period in years. Therefore, we scale the transactions costs by a factor
of 12 in the objective function.
3.5. Testing for the existence of momentum prots
Our simulated portfolio strategy generates a time series of 171 months of portfolio gross returns, portfolio returns net of transactions costs and benchmark
returns. Momentum prots can be tested for with the following regression:
rP;t  rf;t aP bP rB;t  rf;t et

where rP,t denotes the realized monthly return on the active portfolio at time t,
rf,t is the monthly risk-free rate of return, rB,t is the realized monthly benchmark
^ is the realized portfolio beta
return, ^
aP is the ex-post realized monthly alpha, b
P
^
and ^et  rP;t  rf;t  ^
aP  bP rB;t  rf;t is the realized residual return. Simple
returns are used for the regression and appear for all reported results. When
portfolio gross returns (i.e. ignoring any transactions costs) are used in (4), aP is
a risk-adjusted measure of exceptional performance, and we can measure its statistical signicance with the standard t-statistic. When portfolio returns net of
transactions costs are used in (4), aP is a risk-adjusted and transactions costadjusted measure of exceptional performance. Risk-adjusted here means that
the alpha was harvested from returns earned by a portfolio that was formed

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Accounting and Finance  2010 AFAANZ

952

S. Trethewey, T. F. Crack/Accounting and Finance 50 (2010) 941965

using an objective function that included an explicit penalty for risk, and also
that the regression equation removes the portion of portfolio return associated
with the benchmark. The realized ex-post alpha thus accounts for client risk
aversion and benchmark riskwhich are, ultimately, what matter to clients of
institutional asset managers.
4. Results
4.1. The protability of price momentum
Our relatively unconstrained portfolio is designed to be analogous to the
unconstrained strategies reported in the literature, such as Gunasekarage and
Kot (2007). It has an initial investment of $1 and is allowed to short sell, take
active weights of 20 per cent (this is the maximum allowed value of any element
of the vector jhP  hB j in any month) and have a maximum two-sided turnover
of 50 per cent per month. We include penalties for the bid-ask spread and price
impact in the objective function, but the tiny $1 portfolio size means that the
price impact is eectively zero.
Figure 1 and Table 2 provide strong evidence of a momentum eect with
mean monthly returns well in excess of the mean monthly benchmark return and
signicant levels of alpha (i.e. realized abnormal return as in equation (4)) at the
0.1 per cent level for the gross returns and the 1 per cent level for the net returns.
The relatively unconstrained portfolio produces a gross alpha of 112 bps per
month before subtracting transactions costscomparable with Gunasekarage
and Kot (2007). This strategy is, however, not realistic because a larger fund
would push prices against it as it walks up or down the CLOB. Also, although
short selling is allowed in New Zealand, it is not widely used. Finally, the strategy pushes the two-sided turnover constraint of 50 per cent to the limit every
time the portfolio is rebalanced. This indicates that the returns will be severely
decreased once price impact is considered and turnover is properly constrained.
Net of transactions costs (eectively the relative spread only in this case), the relatively unconstrained portfolio still produces a monthly alpha of 87 bps per
month and a good information ratio (i.e. Sharpe ratio calculated using residual
returns) of IR = 0.67.
The last two rows of Table 2 show that removing the ability to short and tightening the turnover and active weight constraints immediately kills o more than
three-quarters of the realized alpha; the IR on the constrained $1 portfolio is still
good, however, and is 0.47 after transactions costs.
In all portfolios reported in Table 2, unintentional benchmark timing caused a
slight decrease in portfolio return. We constrained our ex-ante portfolio beta to
equal 1 when we rebalanced each month, but in a real-world trading strategy,
the portfolio managers would rebalance something like 10 times per month
(whenever exposure to the recalculated ex-ante alphas falls far enough to warrant
the transactions costs of a rebalance). Our monthly rebalance is infrequent
 2010 The Authors
Accounting and Finance  2010 AFAANZ

Cumulative level

S. Trethewey, T. F. Crack/Accounting and Finance 50 (2010) 941965


1900
1800
1700
1600
1500
1400
1300
1200
1100
1000
900
800
700
600
500
400
300
200
100
0
Jun-1992

953

$1 Portfolio, relatively unconstrained, gross return


$1 Portfolio, relatively unconstrained, net return
$1 Portfolio, constrained, gross return
$1 Portfolio, constrained, net return
Benchmark (NZSE40/NZX50)

Jun-1994

May-1996

May-1998

May-2000

May-2002

May-2004

May-2006

All portfolios are momentum strategies with an initial fund value of $1. The relatively unconstrained portfolios are allowed to short sell and
have a maximum turnover of 50 per cent, and a maximum active weight of 20 per cent. The constrained portfolios are not allowed to short sell and have a
maximum turnover of 20 per cent and a maximum active weight of 5 per cent. Gross return refers to the estimated portfolio return prior to transaction costs.
Net return refers to the estimated portfolio return after transaction costs (i.e. spreads and price impact).

Figure 1 Protability of relatively unconstrained return momentum strategies.

enough that our portfolio betas slip away from 1, which introduces unintentional
benchmark timing. We focus on the ex-post alpha ^aP rather than on the active
return 
rP  
rB because the alpha represents the intentional return to stock selection, whereas the active return includes the unintentional benchmark timing
return.
Table 3 reports the results for trading strategies where we have estimated a
more realistic portfolio than in Table 2. Each of these strategies was implemented with a $100 million initial portfolio, no short selling, an active weight
constraint of 5 per cent and a two-sided turnover constraint of 20 per cent per
month. We also report strategies with dierent ex-ante alpha constructions (with
and without a one-month gap and using three or six months for the formation
period).
Although the mean gross return to the realistic portfolios in Panel A and Panel
B of Table 3 exceeds the mean return to the benchmark, we see that without
exception the gross alphas are economically small and statistically insignicant,
and the net alphas are statistically signicantly negative at the 0.1 per cent level.
The benets of stepping away from the benchmark have therefore failed to
exceed the cost of doing so. Real-world constraints mean that we have not been
able to capture the promising momentum prots we saw in the relatively unconstrained portfolios in Table 2.
An asterisk in Table 3 marks our base portfolio. In the remainder of the
paper, we vary its characteristics/constraints to deduce which are pivotal in
destroying the prots we saw in the relatively unconstrained case.
 2010 The Authors
Accounting and Finance  2010 AFAANZ

 2010 The Authors


Accounting and Finance  2010 AFAANZ

171
171
171
171
171

Benchmark
Rel. Unconstrained, Gross Return
Rel. Unconstrained, Net Return
Constrained, Gross Return
Constrained, Net Return

0.78%
1.85%
1.60%
1.00%
0.94%

0.04460
0.05601
0.05662
0.04305
0.04297

StdDev of
Returns

1.12%
0.87%
0.24%
0.18%

Alpha

3.29
2.54
2.33
1.76

Alpha
t-value

0.770
0.781
0.918
0.918

Beta

)0.230
)0.219
)0.082
)0.082

Active
Beta

)0.05%
)0.05%
)0.02%
)0.02%

Bmark
Timing
Return

0.87
0.67
0.62
0.47

Resid.
IR

0.376
0.378
0.905
0.908

R2

101.7
102.8
1611.0
1666.8

F
Stat

All estimates are monthly. N is the number of monthly rebalances. All portfolios have a six-month formation period, with a one-month gap prior to the
holding period. The relatively unconstrained portfolios are allowed to short sell and have a maximum turnover of 50 per cent and a maximum active weight
of 20 per cent. The constrained portfolios are not allowed to short sell and have a maximum turnover of 20 per cent and a maximum active weight of 5 per
cent. All portfolios have an initial value of $1. Gross return refers to the estimated portfolio return prior to transaction costs. Net return refers to the estimated portfolio return after transaction costs (i.e. spreads and price impact). All portfolios were constrained to have ex-ante beta of 1 at each monthly rebalance. All F-Stats are signicant at better than 1 per cent.

Portfolio

Mean
Return

Table 2
Relatively unconstrained return momentum strategies

954
S. Trethewey, T. F. Crack/Accounting and Finance 50 (2010) 941965

 2010 The Authors


Accounting and Finance  2010 AFAANZ
0.04460
0.04309
0.04441
0.04362
0.04363
0.04360
0.04342
0.04298
0.04369
0.04298
0.04383
0.04369

0.82%
0.49%
0.84%
0.50%

0.80%
0.45%
0.80%
0.52%

0.80%
0.78%

0.52%

StdDev of
Returns

0.78%

Mean
Return

0.60
0.05
)3.84

)0.25%

0.53
)5.37
0.60
)3.84

0.87
)4.46
1.20
)4.25

0.03%
0.00%

0.03%
)0.32%
0.03%
)0.25%

0.05%
)0.29%
0.07%
)0.27%

Alpha

Alpha
t-value

0.961

0.949
0.969

0.962
0.958
0.949
0.961

0.951
0.977
0.962
0.960

Beta

)0.01%
)0.01%

)0.051
)0.031

)0.01%

)0.01%
)0.01%
)0.01%
)0.01%

)0.038
)0.042
)0.051
)0.039

)0.039

)0.01%
)0.01%
)0.01%
)0.01%

Bmark
Timing
Return

)0.049
)0.023
)0.038
)0.040

Active
Beta

)1.02

0.16
0.01

0.14
)1.42
0.16
)1.02

0.23
)1.18
0.32
)1.13

Resid. IR

0.962

0.970
0.972

0.969
0.969
0.970
0.962

0.969
0.964
0.967
0.964

R2

4270.3

5539.8
5807.4

5224.1
5222.1
5539.8
4270.3

5299.4
4541.2
5021.0
4565.1

F
Stat

All estimates are monthly. N is the number of monthly rebalances. No gap refers to immediate investment after the formation period. All portfolios have
an initial value of $100 million, maximum turnover of 20 per cent and maximum active weight of 5 per cent. One-month gap refers to leaving a one-month
gap between the formation and holding period to remove any potential reversal eects. The number of rebalances indicates the length in months of the strategy formation period. Gross return refers to the estimated portfolio return prior to transactions costs. Net return refers to the estimated portfolio return after
transaction costs. Gross return less relative spread refers to the estimated portfolio return after the relative spread transactions costs have been removed, but
before the price impact costs have been removed. All F-Stats are signicant at better than 1 per cent.
*The base portfolio: initial value of $100 million, 20 per cent maximum turnover, 5 per cent maximum active weight, full objective function, six-month formation period and one-month gap until holding period. This portfolio is used for comparison throughout the results.

Benchmark
171
Panel A: No gap
3-Month, Gross Return
171
3-Month, Net Return
171
6-Month, Gross Return
171
6-Month, Net Return
171
Panel B: One-month gap
3-Month, Gross Return
171
3-Month, Net Return
171
6-Month, Gross Return*
171
6-Month, Net Return
171
Panel C: The eect of transactions costs
6-Month, Gross Return*
171
6-Month, Gross Return
171
less Relative Spread
6-Month, Net Return
171

Formation-Return
Combination

Table 3
Transactions costs and the protability of return momentum strategies

S. Trethewey, T. F. Crack/Accounting and Finance 50 (2010) 941965


955

956

S. Trethewey, T. F. Crack/Accounting and Finance 50 (2010) 941965

375
350
$100m base portfolio, gross return

325

$100m base portfolio, gross return less relative spreads

Cumulative level

300

$100m base portfolio, net return

275

Benchmark (NZSE40/NZX50)

250
225
200
175
150
125
100
75
Jun-1992

Jun-1994

May-1996

May-1998

May-2000

May-2002

May-2004

May-2006

All portfolios are momentum strategies that are variations, by transaction costs only, of the base portfolio*. Gross return refers to the estimated portfolio return
prior to transaction costs. Net return refers to the estimated portfolio return after transaction costs (i.e. spreads and price impact). Gross return less relative spread
refers to the estimated portfolio return after the relative spread transaction costs have been removed. *The base portfolio: initial value of $100 million, 20 per cent
maximum turnover, 5 per cent maximum active weight, full objective function, six-month formation period and one-month gap until holding period.

Figure 2 Transactions costs and the protability of return momentum strategies.

Figure 2 and Panel C of Table 3 demonstrate that deducting the spread component of transactions costs from the gross $100 million base portfolio return
causes the strategy to match the returns of the benchmark within rounding error.
Then, subsequently removing the price impact transaction cost causes the strategy to signicantly underperform the benchmark.
Momentum trading strategies are designed to exploit short-lived eects. It
is not surprising, therefore, that they are reported to have high turnover
(Keim, 2003; Lesmond et al., 2004; Sadka, 2006). For the $100 million base
portfolio, the mean two-sided turnover was 127 per cent per annum, but it
was 697 per cent per annum in the relatively unconstrained portfolio. These
turnovers correspond to average stock holding periods of 9.4 and 1.7 months,
respectively. The shorter holding period brings with it greater momentum
prots (as seen here and in Gunasekarage and Kot, 2007), but the portfolio
turnover required to achieve a short holding period in the base portfolio
involves an infeasible amount of price impact. Although the mean transaction
cost attributable to the spread component was only 5 bps per month, the
mean transaction cost attributable to price impact was 28 bps per month.
Price impact thus accounts for 85 per cent of the transactions costs of the
strategy and cannot be ignored.
Korajczyk and Sadka (2004) also discuss the size of spread and price impact
components of transactions costs for stand-alone momentum strategies, but
they do not explicitly identify the relative sizes of these components. We
deduce that their spread component of transactions costs is in the range of
 2010 The Authors
Accounting and Finance  2010 AFAANZ

S. Trethewey, T. F. Crack/Accounting and Finance 50 (2010) 941965

957

1245 bps per month, depending upon portfolio formation strategy (Korajczyk
and Sadka, 2004, p. 1058). We deduce that their price impact transactions
costs in a USD 5 billion portfolio are in the range 40100 bps per month for
the value- and liquidity-weighted strategies; the particular values in these
ranges depend upon the portfolio formation strategy and the model of price
impact (Korajczyk and Sadka, 2004, Figures 4(a), 5(a), 6(a) and 7(a)). We conclude that their price impact component of transactions costs is, like ours, the
largest part of the transactions costs for any reasonably sized strategy. It is
hardly surprising that their transactions costs are noticeably larger than ours
in absolute magnitude (twice or more), because our optimization includes an
explicit transactions costs penalty in the objective, which means that, like a
practitioners, our portfolios are chosen specically so as to minimize exposure
to stocks with higher transactions costs.
In our implementation, we trade only once per month. We may, therefore, be
overestimating practitioner price impact as a function of dollar volume. Figure 2
and Panel C of Table 3 show, however, that even if price impact were zero, the
base portfolios performance still only matches that of the benchmark. On the
returns side, however, our infrequent rebalancing may lose exposure to ex-ante
alphas, and we may therefore underestimate the ability of the model to gain traction with our alphas.
4.2. The impact of relative spreads and fund size
Table 4 reports estimates of the eects of dierent assumed relative spreads
(Panel A) and initial fund sizes (Panel B) on the performance of the momentum
strategy. All portfolios are compared with our base portfolio and the full form
of the objective function is used.
The results in Panel A of Table 4 show that the mean returns per month of the
momentum strategy are very stable across the variations of relative spread.
Using a blanket 80 bps relative spread for all stocks generates a higher mean
return on a gross and net basis. The performance using the 80 bps spread is only
marginally higher than the performance using a minimum 50 bps spread and
slightly higher again than using actual spreads.
In Panel B of Table 4, all portfolios considered are variations of the base portfolio, with only the initial fund value changing. We can see the alpha and the IR
dropping almost monotonically as the fund size increases and the price impact
begins to bite. The $1 portfolio, with eectively no price impact, predictably produces the highest mean return and a gross alpha of 24 bps per month (the net
alpha for this strategy appeared in Table 2 and was a respectable 18 bps per
month). The eect of the price impact function is not noticeable until the fund
size reaches $10 million. In fund sizes above $50 million, we observe that the
price impact function signicantly retards the strategy from trading in stocks
that produce good alpha.

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Accounting and Finance  2010 AFAANZ

 2010 The Authors


Accounting and Finance  2010 AFAANZ
0.04460
0.04343
0.04297
0.04440
0.04345
0.04298
0.04369
0.04305
0.04283
0.04265
0.04311
0.04298
0.04438

0.78%
0.86%
0.52%
0.82%
0.52%
0.80%
0.52%
1.00%
0.97%
0.90%
0.82%
0.80%
0.84%

StdDev of
Returns

0.24%
0.21%
0.14%
0.05%
0.03%
0.07%

2.33
2.48
2.02
0.80
0.60
1.13

0.60
)3.84

)3.97

)0.25%
0.03%
)0.25%

1.53
)4.00
0.69

0.09%
)0.25%
0.04%

Alpha

Alpha
t-value

0.918
0.928
0.936
0.952
0.949
0.980

0.949
0.961

0.956

0.959
0.946
0.982

Beta

)0.01%
)0.01%
)0.01%
)0.02%
)0.02%
)0.02%
)0.01%
)0.01%
0.00%

)0.051
)0.039
)0.082
)0.072
)0.064
)0.048
)0.051
)0.020

)0.01%
)0.01%
0.00%

Bmark
Timing
Return

)0.044

)0.041
)0.054
)0.018

Active
Beta

0.62
0.66
0.54
0.21
0.16
0.30

0.16
)1.02

)1.05

0.41
)1.06
0.18

Resid.
IR

0.905
0.934
0.958
0.970
0.970
0.970

0.970
0.962

0.964

0.971
0.964
0.973

R2

1611.0
2377.6
3827.4
5457.2
5539.8
5500.0

5539.8
4270.3

4461.8

5645.8
4528.4
6034.9

F
Stat

All estimates are monthly. N is the number of monthly rebalances. All portfolios have a maximum turnover of 20 per cent and maximum active weight of 5
per cent. Panel A contains variations on the relative spread. 80 bps spread refers to all stocks having their relative spread set to a blanket 80 bps. Minimum
50 bps spread refers to all stocks having actual spreads overlaid with a minimum relative spread of 50 bps. Actual spread indicates that the reported bid-ask
spread has been used to calculate the relative spread. All portfolios in Panel A had an initial value of $100 million. Panel B contains variations of the portfolio size by gross returns. Gross return refers to the estimated portfolio return prior to transaction costs. Net return refers to the estimated portfolio return
after transaction costs (i.e. spreads and price impact). All F-Stats are signicant at better than 1 per cent.
*The base portfolio: initial value of $100 million, 20 per cent maximum turnover, 5 per cent maximum active weight, full objective function, six-month formation period and one-month gap until holding period.

Benchmark
171
Panel A: Relative spreads
80 bps spread, Gross Return
171
80 bps spread, Net Return
171
Minimum 50 bps spread,
171
Gross Return
Minimum 50 bps spread,
171
Net Return
Actual spread, Gross Return*
171
Actual spread, Net Return
171
Panel B: Fund size (all gross returns)
$1
171
$1 million
171
$10 million
171
$50 million
171
$100 million*
171
$150 million
171

Portfolio

Mean
Return

Table 4
The eect of relative spreads and fund size on the protability of return momentum strategies

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S. Trethewey, T. F. Crack/Accounting and Finance 50 (2010) 941965

959

4.3. The eect of optimization parameters


Table 5 reports the impact on our base portfolios performance when we vary
the components of the objective function (Panel A and Panel B) or the tightness
of the turnover or active weight constraints (Panels C and Panel D).
Grinold and Kahn (2000a, p. 119) quote high (k 15), moderate (k 10) and
low (k 5) values for client risk aversion. Panel A of Table 5 indicates that,
other things being equal, the tight limits on active weights and turnover and the
presence of the price impact penalty term in the objective function, combined
with the inability to short sell, retard portfolio trade to the extent that the risk
aversion is simply not biting in their presence.
Panel B of Table 5 explores dropping various terms from the full objective
function for the base portfolio. We see that dropping the price impact penalty
in the objective function immediately adds 21 bps per month to the gross
alpha (but unsurprisingly this change destroys approximately 100 bps of net
alpha per month; not reported in the tables). Then, dropping the spread component from the objective function adds an additional 9 bps per month to the
gross alpha. Then, dropping the risk aversion component adds just one more
basis point to the gross alpha but hurts the IR because of the additional active
risk taken on.
Looking at Panels C and D of Table 5, we can see that relaxing the turnover
and active weight constraints has only a slight eect on gross returns unless the
price impact penalty term in the objective is removed, in which case the eect on
gross alpha is signicant, jumping by 27 bps per month (but again unsurprisingly
this change destroys approximately 200 bps of net alpha per month; not reported
in the tables). Then also dropping the risk aversion down to k 5 has only a
marginal impact on alpha but again hurts the IR through additional active risk
taken on. The implication is that the price impact and risk aversion penalty
terms are important for retarding alpha chasing that would otherwise be blind to
transactions costs or active risk, respectively.
4.4. Market capitalization, winners, losers and shorts
Ignoring transactions costs, the small capitalization holdings of our base
portfolio generate 50 bps of alpha per month (compared with 30 bps of alpha
generated per month by their na ve sub-index portfolio).3 The large capitalization holdings of the base portfolio lose 24 bps of alpha per month (roughly
matching their sub-index portfolio). These results are consistent with Lesmond
et al. (2004), who nd that the stocks that generate large momentum returns
are precisely those stocks with high trading costs. No wonder we found that

Full details of the return attributions in this section are available from the authors upon
request.
 2010 The Authors
Accounting and Finance  2010 AFAANZ

Benchmark
171
0.78%
Panel A: Risk aversion
Lambda = 5
171
0.85%
Lambda = 10*
171
0.80%
Lambda = 15
171
0.83%
Panel B: Objective function
Active Return
171
1.09%
Active Return and Active Risk
171
1.09%
Active Return, Active Risk, and
171
1.00%
Relative Spreads
Active Return, Active Risk, and Full
171
0.80%
Transactions Costs*
Panel C: Constraint levels
Turnover 50%, Active Weight 5%
171
0.80%
Turnover 20%, Active Weight 5%*
171
0.80%
Turnover 10%, Active Weight 5%
171
0.84%
Turnover 20%, Active Weight 10%
171
0.83%
Turnover 20%, Active Weight 20%
171
0.87%
Panel D: Variations on base portfolio constraints and penalties
Turnover 20%, Active Weight 5%*
171
0.80%
Turnover 50%, Active Weight 20%
171
0.82%
Turnover 50%, Active Weight 20%,
171
1.06%
No PI in Obj. Fn.

Portfolio

Mean
Return

0.08%
0.03%
0.05%
0.34%
0.33%
0.24%
0.03%

0.03%
0.03%
0.07%
0.06%
0.10%
0.03%
0.04%
0.31%

0.04301
0.04316
0.04306
0.04298

0.04317
0.04298
0.04351
0.04282
0.04374
0.04298
0.04349
0.04327

Alpha

0.04344
0.04298
0.04389

0.04460

StdDev of
Returns

 2010 The Authors


Accounting and Finance  2010 AFAANZ
0.60
0.70
2.14

0.58
0.60
1.08
0.96
1.46

0.60

2.69
3.13
2.35

1.36
0.60
0.95

Alpha
t-value

0.949
0.957
0.873

0.954
0.949
0.958
0.943
0.961

0.949

0.892
0.919
0.918

0.958
0.949
0.971

Beta

)0.01%
)0.01%
)0.01%
)0.03%
)0.02%
)0.02%
)0.01%
)0.01%
)0.01%
)0.01%
)0.01%
)0.01%
)0.01%
)0.01%
)0.03%

)0.108
)0.081
)0.082
)0.051
)0.046
)0.051
)0.042
)0.057
)0.039
)0.051
)0.043
)0.127

Bmark
Timing
Return

)0.042
)0.051
)0.029

Active
Beta

Table 5
The eect of the optimisation parameters on the protability of return momentum strategies (all gross returns)

0.16
0.19
0.57

0.15
0.16
0.29
0.25
0.39

0.16

0.71
0.83
0.62

0.36
0.16
0.25

Resid.
IR

0.970
0.964
0.808

0.972
0.970
0.964
0.965
0.961

0.970

0.856
0.902
0.905

0.968
0.970
0.974

R2

5539.8
4551.8
710.9

5871.4
5539.8
4512.8
4722.5
4124.4

5539.8

1004.9
1547.5
1607.3

5140.7
5539.8
6455.2

F
Stat

960
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Accounting and Finance  2010 AFAANZ

171

N
1.07%

Mean
Return
0.04486

StdDev of
Returns
0.32%

Alpha
1.75

Alpha
t-value
0.850

Beta

Bmark
Timing
Return
)0.04%

Active
Beta
)0.150

0.47

Resid.
IR

0.713

R2

420.5

F
Stat

All estimates are monthly. N is the number of monthly rebalances. All portfolios have an initial value of $100 million and are gross return variants of the
base portfolio* with the specied parameters altered. Within Panel A, lambda is the client risk aversion coecient used in the objective function. Higher levels of lambda represent greater risk aversion. The levels of risk aversion where chosen following Grinold and Kahn (2000a, p. 119). In Panel B, the portfolios
refer to variations on the form of the objective function. Full transactions costs is the sum of relative spreads and price impact costs. Within Panel C, the constraint levels represent the maximum level of active weight or turnover that the portfolio may have each time it is rebalanced. The portfolios in Panel D are
variations on the base portfolio with changes in the constraints and the objective function penalties (PI refers to price impact). All F-Stats are signicant at
better than 1 per cent.
*The base portfolio: initial value of $100 million, 20 per cent maximum turnover, 5 per cent maximum active weight, full objective function, six-month formation period and one-month gap until holding period.

Turnover 50%, Active Weight 20%,


No PI in Obj. Fn.,
Lambda = 5

Portfolio

Table 5 (continued)

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961

962

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the price impact term is so biting, given that price impact is greater in small
stocks and that it is the small stocks that are providing the ex-post alpha performance.
Again, ignoring transactions costs, the winner (i.e. overweight) sub-portfolio
of our base portfolio generates 20 bps of alpha per month (compared with
14 bps of alpha generated by its na ve sub-index portfolio), but the loser (i.e.
underweight) sub-portfolio loses 32 bps of alpha per month (compared with
13 bps of alpha lost by its na ve sub-index portfolio). In the relatively unconstrained portfolio, however, winners generate 36 bps of alpha per month (compared with 8 bps of alpha generated by their sub-index, losers (underweight but
not short) roughly match their sub-index, and shorts generate 46 bps of alpha
more per month than the )3 bps provided by their sub-index portfolio. The
short constraint in the base portfolio thus confounds the ability of the optimizer
to correctly weight the underachievers, and, by doing so, confounds the ability
for the optimizer to correctly exploit the winners (see related discussion in
Grinold and Kahn, 2000a, p. 421 and Grinold and Kahn, 2000b).
The importance of the short position here is also consistent with earlier literature that nds that stock prices are more likely to underreact to bad news
than to good news (Hong et al., 2000, p. 277), and, as such, the ability to
short the losers is very valuable. Similarly, Lee and Swaminathan (2000, Table
I) and Lesmond et al. (2004, Table 1) nd that portfolios of loser stocks subsequently underperform average stocks by more than winner stocks outperform
them.
Gunasekarage and Kot (2007, p. 120) consider long-only portfolios, and they
also nd that the winners are driving the momentum prots. In contrast to us,
however, they say that it is the larger capitalization stocks that generate alpha.
They have a much broader sample of stocks than ours, and our small stocks
probably account for half of their large stocks, while our large stocks have no
impact at all.
If we were to trade only the highly liquid stocks, we could reduce the liquidity
problems and minimize price impact. This is what Stork (2008) does, with
reported protability before transactions costs. Unfortunately, concentrated
portfolios of only a few stocks are not attractive to institutional asset managers.
The active risk is simply too high, and, if implemented in any size, price impact
would again become an issue. On top of these problems, our analysis indicates
that the momentum prots are predominantly sourced in the smaller capitalization stocks. For all these reasons, we believe a concentrated high-liquidity strategy is not feasible.
Although the net returns to all of our realistic portfolios are negative, the
momentum strategy may be useful as one of a group of alpha signals implemented simultaneously, or as a trade timing indicatorwhen you have to get
a trade completed and want to know whether you should wait to execute it or
not.

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S. Trethewey, T. F. Crack/Accounting and Finance 50 (2010) 941965

963

5. Conclusion
We test whether recently reported prots from price momentum trading strategies in the New Zealand stock market (Gunasekarage and Kot, 2007; Stork,
2008) are able to be captured using a simulated portfolio trading strategy. Within
the NZSE40/NZX50 index, the smaller stocks generate gross momentum prots,
but have high spreads and low turnover; the low turnover, in turn, implies high
price impact. In a tiny unconstrained portfolio, smaller stocks, winner stocks
and shorts combine to generate gross performance so exceptional that performance net of spreads is excellent (and price impact is negligible). In a portfolio
of any size and with short sale constraints, however, transactions cost avoidance
and risk aversion necessarily retard trade in the smaller stocks, winner stocks
provide no prots and shorts are unavailable. In this case, the trading strategy
still steps away from the benchmark to chase anticipated momentum prots, but
gross returns are less than anticipated and only just cover bid-ask spread costs;
portfolio size combined with high turnover in small stocks means that once price
impact is accounted for, performance lags the index. A proper accounting
for transactions costs and risk has therefore reversed the nding of the earlier literature.
A particular strength of our analysis is the introduction of a practitioner technique (quantitative active equity alpha optimization) for optimal portfolio rebalancing subject to risk and transactions costs. This technique is broadly
applicable to simulated trading strategies, but we have not seen it used elsewhere
in the academic literature.
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