A Review of Alpha Architect’s (Wes Gray/Jack Vogel) Quantitative Momentum book

This post will be an in-depth review of Alpha Architect’s Quantitative Momentum book. Overall, in my opinion, the book is terrific for those that are practitioners in fund management in the individual equity space, and still contains ideas worth thinking about outside of that space. However, the system detailed in the book benefits from nested ranking (rank along axis X, take the top decile, rank along axis Y within the top decile in X, and take the top decile along axis Y, essentially restricting selection to 1% of the universe). Furthermore, the book does not do much to touch upon volatility controls, which may have enhanced the system outlined greatly.

Before I get into the brunt of this post, I’d like to let my readers know that I formalized my nuts and bolts of quantstrat series of posts as a formal datacamp course. Datacamp is a very cheap way to learn a bunch of R, and financial applications are among those topics. My course covers the basics of quantstrat, and if those who complete the course like it, I may very well create more advanced quantstrat modules on datacamp. I’m hoping that the finance courses are well-received, since there are financial topics in R I’d like to learn myself that a 45 minute lecture doesn’t really suffice for (such as Dr. David Matteson’s change points magic, PortfolioAnalytics, and so on). In any case, here’s the link.

So, let’s start with a summary of the book:

Part 1 is several chapters that are the giant expose- of why momentum works (or at least, has worked for at least 20 years since 1993)…namely that human biases and irrational behaviors act in certain ways to make the anomaly work. Then there’s also the career risk (AKA it’s a risk factor, and so, if your benchmark is SPY and you run across a 3+ year period of underperformance, you have severe career risk), and essentially, a whole litany of why a professional asset manager would get fired but if you just stick with the anomaly over many many years and ride out multi-year stretches of relative underperformance, you’ll come out ahead in the very long run.

Generally, I feel like there’s work to be done if this is the best that can be done, but okay, I’ll accept it.

Essentially, part 1 is for the uninitiated. For those that have been around the momentum block a couple of times, they can skip right past this. Unfortunately, it’s half the book, so that leaves a little bit of a sour taste in the mouth.

Next, part two is where, in my opinion, the real meat and potatoes of the book–the “how”.

Essentially, the algorithm can be boiled down into the following:

Taking the universe of large and mid-cap stocks, do the following:

1) Sort the stocks into deciles by 2-12 momentum–that is, at the end of every month, calculate momentum by last month’s closing price minus the closing price 12 months ago. Essentially, research states that there’s a reversion effect on the 1-month momentum. However, this effect doesn’t carry over into the ETF universe in my experience.

2) Here’s the interesting part which makes the book worth picking up on its own (in my opinion): after sorting into deciles, rank the top decile by the following metric: multiply the sign of the 2-12 momentum by the following equation: (% negative returns – % positive). Essentially, the idea here is to determine smoothness of momentum. That is, in the most extreme situation, imagine a stock that did absolutely nothing for 230 days, and then had one massive day that gave it its entire price appreciation (think Google when it had a 10% jump off of better-than-expected numbers reports), and in the other extreme, a stock that simply had each and every single day be a small positive price appreciation. Obviously, you’d want the second type of stock. That’s this idea. Again, sort into deciles, and take the top decile. Therefore, taking the top decile of the top decile leaves you with 1% of the universe. Essentially, this makes the idea very difficult to replicate–since you’d need to track down a massive universe of stocks. That stated, I think the expression is actually a pretty good idea as a stand-in for volatility. That is, regardless of how volatile an asset is–whether it’s as volatile as a commodity like DBC, or as non-volatile as a fixed-income product like SHY, this expression is an interesting way of stating “this path is choppy” vs. “this path is smooth”. I might investigate this expression on my blog further in the future.

3) Lastly, if the portfolio is turning over quarterly instead of monthly, the best months to turn it over are the months preceding end-of-quarter month (that is, February, May, August, November) because a bunch of amateur asset managers like to “window dress” their portfolios. That is, they had a crummy quarter, so at the last month before they have to send out quarterly statements, they load up on some recent winners so that their clients don’t think they’re as amateur as they really let on, and there’s a bump for this. Similarly, January has some selling anomalies due to tax-loss harvesting. As far as practical implementations go, I think this is a very nice touch. Conceding the fact that turning over every month may be a bit too expensive, I like that Wes and Jack say “sure, you want to turn it over once every three months, but on *which* months?”. It’s a very good question to ask if it means you get an additional percentage point or 150 bps a year from that, as it just might cover the transaction costs and then some.

All in all, it’s a fairly simple to understand strategy. However, the part that sort of gates off the book to a perfect replication is the difficulty in obtaining the CRSP data.

However, I do commend Alpha Architect for disclosing the entire algorithm from start to finish.

Furthermore, if the basic 2-12 momentum is not enough, there’s an appendix detailing other types of momentum ideas (earnings momentum, ranking by distance to 52-week highs, absolute historical momentum, and so on). None of these strategies are really that much better than the basic price momentum strategy, so they’re there for those interested, but it seems there’s nothing really ground-breaking there. That is, if you’re trading once a month, there’s only so many ways of saying “hey, I think this thing is going up!”

I also like that Wes and Jack touched on the fact that trend-following, while it doesn’t improve overall CAGR or Sharpe, does a massive amount to improve on max drawdown. That is, if faced with the prospect of losing 70-80% of everything, and losing only 30%, that’s an easy choice to make. Trend-following is good, even a simplistic version.

All in all, I think the book accomplishes what it sets out to do, which is to present a well-researched algorithm. Ultimately, the punchline is on Alpha Architect’s site (I believe they have some sort of monthly stock filter). Furthermore, the book states that there are better risk-adjusted returns when combined with the algorithm outlined in the “quantitative value” book. In my experience, I’ve never had value algorithms impress me in the backtests I’ve done, but I can chalk that up to me being inexperienced with all the various valuation metrics.

My criticism of the book, however, is this:

The momentum algorithm in the book misses what I feel is one key component: volatility targeting control. Simply, the paper “momentum has its moments” (which I covered in my hypothesis-driven development series of posts) essentially states that the usual Fama-French momentum strategy does far better from a risk-reward strategy by deleveraging during times of excessive volatility, and avoiding momentum crashes. I’m not sure why Wes and Jack didn’t touch upon this paper, since the implementation is very simple (target/realized volatility = leverage factor). Ideally, I’d love if Wes or Jack could send me the stream of returns for this strategy (preferably daily, but monthly also works).

Essentially, I think this book is very comprehensive. However, I think it also has a somewhat “don’t try this at home” feel to it due to the data requirement to replicate it. Certainly, if your broker charges you $8 a transaction, it’s not a feasible strategy to drop several thousand bucks a year on transaction costs that’ll just give your returns to your broker. However, I do wonder if the QMOM ETF (from Alpha Architect, of course) is, in fact, a better version of this strategy, outside of the management fee.

In any case, my final opinion is this: while this book leaves a little bit of knowledge on the table, on a whole, it accomplishes what it sets out to do, is clear with its procedures, and provides several worthwhile ideas. For the price of a non-technical textbook (aka those $60+ books on amazon), this book is a steal.

4.5/5 stars.

Thanks for reading.

NOTE: While I am currently employed in a successful analytics capacity, I am interested in hearing about full-time positions more closely related to the topics on this blog. If you have a full-time position which can benefit from my current skills, please let me know. My Linkedin can be found here.