Case Study About AQR’s Momentum Fund

Answer 1:

An investment fund that is based on current trends is known as a momentum fund. The trends that are usually observed include trends of price movements and earnings.  Thus, the managers invest in the companies that have positive momentum, and they may also sell the stock of the companies that have negative momentum.  Further, individuals must invest in such types of funds as these funds contain a high probability of fetching high-return investments. However, it is important to understand that these funds require a high level of monitoring because the directional changes might occur during the period, and the momentum factors can be short-term.

They consider different characteristics of a stock and thus end up with an informed investing decision.  The most common factors considered while analyzing whether to invest in the momentum fund or not include earnings, price movement, and revenue.  The investors must utilize the benefits offered by momentum investing in these funds.  There are various other companies that offer this type of investment. However, AQR is the most suitable option available to investors at the moment. AQR was established in 1998 and has grown rapidly over the years. After the company entered into the mutual fund market, it focused on the financial advisor channel.  It developed three separate long-only momentum indexes over the years and operated through them. These indices are known as a small-cap momentum index, a large-cap momentum index and a large-cap international momentum index.  The company possesses a “back-test” to demonstrate to its investors that the momentum strategies offer strong performance potential.

However, there are also certain risks that such momentum funds contain that must be known to the investors.  They must understand the factors that are considered while constructing a portfolio.  For instance, there are funds that only focus on the past performance of the company and others that not only follow the performance momentum but also consider the expectations for the future as well.

Answer 2:

Yes. The ties work in both cases. Research studies suggest that social networks provide easy accessibility to resources and information and allow sharing and coordination. Thus, those who have strong connections and are socially active are in a better position relative to those investors who do not have such connections. It is because the social connections regulate the behaviour of the society. They influence the behaviour by affirming or negating them. Further, it is easier to verify information on social networks. These social relations can thus help an organization get benefits by seeking an adequate level of financing. This notion can be explained well by the embeddedness approach; this concept explains why economic transactions become embedded in social relations and thus differentially affect the valuation and allocation of resources. Further, there has been a debate that due to the efficient market hypothesis, stock returns cannot be predicted (Hong, 1999). However, recent studies show that information is a major factor that has the potential to influence stock returns (Qian, 2007). Also, the information contained through social media reaches a broad audience (Risius et al., 2015).

However, there are negative implications of such social connections as well. For instance, these social connections also contain the probability of restricting actions by imposing normative behaviour. Moreover, a gradual Information flow model highlights that the contemporary world differs in two different ways, as assumed by the EMH. Firstly, some information is restricted as private and is not available to the public. Secondly, even if the information is disclosed to the investors, their cognitive biases tend to limit their ability to perceive the information (Sul & Yuan 2017).

Research studies on momentum trading have shown the consensus on the point that in the intermediate horizon, where the period remains between three to 12 months, the stock returns show persistence in generating returns. However, the reasons for such persistence may differ. It depends on the factors at the core of the momentum funds, which are kept under consideration while formulating such funds.  There are also considerations regarding a view that associates abnormal returns with momentum strategies, suggesting that these momentum strategies fetch abnormal returns as compensation for the unidentified source of non-diversifiable risk (Carhart, 1997). Further, studies also suggest that earning-related news also plays a significant role in price momentum trading (Burch, 2002). This study also strengthens the notion of social connectedness as well. Social connectedness also affirms the theory of efficient market hypothesis. Thus, when the information is available to all the investors, the tendency, inclination, and probability of buying such funds increases. It is very important to know what type of information is being rotated in these social networks as it works and vice versa as well.

Research studies suggest that naïve investors may also cause the momentum with biased expectations (Hvidkjaer, 2009). It has also been studied that individuals may use heuristics or cognitive biases, causing them to suffer. That is the reason these individuals rely on particular models of risk and expected return. Thus, using these models, investors tend to buy or sell the same securities at the same time.  To conclude, the cognitive biases of the individuals and prices tend to formulate the behaviours of the individuals. This is linked to the social connection as well. In an environment of increased networking and social connection, such factors contain the probability of creating negative ties. Thus, it is very important to understand the behavioural disposition of the abnormal returns, that they are either due to the proposed explanation of the behaviour or they are caused by rational motivations. Thus, social connectedness works at both ends.

The social impacts of the fund relate to the effect of trading in these funds on society. The literature review exhibits that social impact investment brings positive changes in the lives of the beneficiaries in multiple spectrums of life. Such as social, political, health and wealth (Vanclay, 2003). Further, such social impact investments are made with the intention of causing a visible and measurable social impact that can also provide a financial upside. In the case of momentum funds, there are studies which assert that reliance on momentum funds may make people feel uncomfortable. The reason behind this is that the momentum effect refers to the propensity with which the relative winning stocks kept on winning and the losing stock kept on losing. However, this tendency can be curbed by the investors by adopting the mechanistic momentum strategies. Further, momentum trading does not put much emphasis on the fundamentals of the company and thus is saved from redeeming the social merit as well. It puts more emphasis on the value of the company.

Moreover, social impact contains different dimensions; thus, it is difficult to measure social impact universally using single metrics. However, there are two approaches that can assist in measuring social impact. One method through which the social impact can be measured is the comparison of anticipated social benefits which are incurred against the costs. The other method is the theory of change. This method causes to explain the process through which the positive social impact has been created.

To sum up, social connections play an important role in increasing the importance and potential of a fund among the public so that individual investors may look forward to investing in it. Such an impact can be measured by looking at the trends and the behaviours of the people towards the funds that are being offered. Research studies suggest that social ties and networks play a significant role in financial contexts, and in a broader sense, they also influence the decisions and outcomes of managers and directors (Bertrand and Schoar, 2003; Xuan, 2009).

Answer 3:

The strategy of AQR and the traditional index funds differ in the following areas. Firstly, traditional strategies may sell stocks, which might produce losses to maximize returns; however, stocks under momentum strategy are only those that bring profitability and are termed winner stocks. Secondly, AQR, being an open-ended mutual fund, requires maintaining liquidity so that it shall be in a position to return the funds to the investors when they demand in the future, while the other funds can require a lock-up period and also may require a notice period to repay the amount back to the investors. Finally, the strategy required by the regulators by AQR tends to be well diversified. The company estimates the risk and return dynamics on a regular basis.

Moreover, the company offered hedge funds to mutual investors and mutual funds to all investors. Thus, these funds, where on hand, can outperform the other indexes, also contain the probability that in case of wrong decisions, they might cause increased costs and eliminate their appeal to the investors, which is not the case with the other indexed funds.

Lastly, there are costs associated with the implementation of actual momentum strategies.  Research studies suggest that there is information available on the stock returns and the observable variables. Also, information regarding the known variables, such as the ratio to price/book and the changes in the prior prices, is also available. However, the findings regarding the distinction between the realizable returns and the returns to the simulated strategies are often not available. The evidence related to size and value is available, but this is not the case in momentum trading.

Answer 4:

Momentum fund theory, as defined by AQR, suggests that it is a phenomenon that says that the stocks shall perform well in the future as well as they have performed in the past compared to the other winning stocks and vice versa. Further, relative performance is the key factor in the study of momentum theory, as it suggests that a strategy shall be implemented without considering the ups or downs of the market.  Keeping this view in mind, along with the fact that there is a neglected firm effect, also plays an important role in the application of momentum stocks. The concept of neglected firms states that those firms which are lesser publically known firms bring more abnormal risk-adjusted returns on their stocks. The concept is affirmed by the literature, where many investors believe that the strategies that are easily explained, such as momentum strategies, lost their efficacy by the time they became known by the majority of the people. Moreover, the impact of social connections cannot be ignored in this regard. That plays an important role in disseminating the information, whether good or bad and ratifying the validity of the momentum fund by any company. Thus, it can be concluded that if such factors remain constant, things will work smoothly; however, on the other hand, the theory contains the probability of negating itself.

Research studies argue that the momentum in the prices of the stock reflects the manifestation of the behaviour in a trade by the market participants. These participants condition the trade on the basis of prior price movements. For instance, positive feedback strategies help them to fetch the results they aspire to. The behaviour manifested by such trading violates the usual norms of rationality narrated by the Efficient Market Hypothesis. A number of studies have also attempted to fit this model in the frame of behaviours offered by the psychological paradigms. They attributed the patterns of investor trading either as an under-reaction or as an over-reaction while matching them to the perceived information obtained prior to the price movements.

To illustrate the effect caused by the momentum trading on the stock returns, Jegadeesh and Titman (1993) formed equal-weighted portfolios and based these on the deciles of ranking by all NYSE and AMEX stocks. These stocks were based on the prior-j-month return. By j-month, that means 3, 6,9 and 12. The period of analysis was taken from 1965 to 1989.  According to this scenario, the strategy bought ten stocks (winners) and sold one stock (loser). The profit was the net return manifested in the long short-position as measured over the holding period mentioned above. The portfolio holdings began after one month of the portfolio creation. The purpose of this was to avoid any sort of micro-structure effects caused by the returns. The trading showed inconsistent results, and the profits ranged from 0.69% to 1.49%. This reflects the inconsistency which may be caused by such funds negating the theory on which they are based. Further, in this illustration, one important point of consideration was that the stocks that the portfolio contained did not change during the period of portfolio holding and that the portfolios were rebalanced to equal weights every month.

References

Bertrand, M., Schoar, A., 2003. Managing with style: the effect of managers on firm policies. Quarterly Journal of Economics 118, 1169–1208

Burch, T.R. and B. Swaminathan, 2002, “Earnings news and institutional trading,” working paper (Cornell University).

Carhart, M., 1997, “On persistence in mutual fund returns,” Journal of Finance 52, 83-110.

Hong, H., & Stein, J. C. (1999). A unified theory of underreaction, momentum trading, and overreaction in asset markets. The Journal of Finance, 54(6), 2143–2184.

Hvidkjaer, S., 2006. A trade-based analysis of momentum. The Review of Financial Studies, 19(2), pp.457-491.

Qian, B., & Rasheed, K., (2007). Stock market prediction with multiple classifiers. Applied Intelligence, 26(1), 25–33.

Risius, M., Akolk, F., & Beck, R. (2015). Differential emotions and the stock market—The case of company-specific trading. European Conference on Information Systems, Completed Research Papers, Munster, Germany, Paper 147.

Sul, H.K., Dennis, A.R. and Yuan, L.I., 2017. Trading on Twitter: Using social media sentiment to predict stock returns. Decision Sciences, 48(3), pp.454-488.

Vanclay, F., 2003. International principles for social impact assessment. Impact assessment and project appraisal, 21(1), pp.5-12.

Xuan, Y., 2009. Empire-building or bridge-building? Evidence from new CEOs’ internal capital allocation decisions. Review of Financial Studies 22, 4919–4948.