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1 March 2018 CFA Institute Journal Review

Momentum, Idiosyncratic Volatility and Market Dynamics: Evidence from China (Digest Summary)

  1. Sandra Krueger, CFA
Evaluating momentum strategies for Chinese equity markets, the authors find no relationship with idiosyncratic (firm-specific) volatility. Differences in stock market dynamics help explain variances in momentum returns across countries/regions.

How Is This Research Useful to Practitioners?

Momentum strategies are used to exploit trends in equity markets. Academic research has shown that momentum returns can be improved by selecting shares with high idiosyncratic volatility (IV)—stock specific and diversifiable volatility. The authors test this research and find that IV does not improve returns in Chinese equity markets.

The authors find that momentum returns in China follow downward trends exclusively. Thus, it is difficult to add significant value owing to the limited number of down states.

As China opens its equity market to foreign investors, demand for actively managed portfolios is expected to increase. Although it is often tempting to apply US equity strategies to China, the authors’ findings suggest that using idiosyncratic volatility as a factor adds no value to momentum strategies. The Chinese equity market has market dynamics different from that of other stock markets because it is dominated by retail investors who treat it like a casino. Typically, A-shares are traded more on rumors and speculation than on fundamentals. Stock financing is a small portion (< 5%) of Chinese corporate balance sheets. Corporate control is not a factor in the valuation of Chinese stock prices. The authors find that momentum returns in China are generally low. Investor expectations and/or portfolio fees need to be set with this outcome in mind.

How Did the Authors Conduct This Research?

The authors’ sample includes all A-shares listed on the Shanghai and Shenzhen stock exchanges. The authors use 22 years of data covering January 1994–August 2016. The portfolio starts with 240 firms, increasing to 1,755 at the end of the sample period. The authors form quintile portfolios whereby all stocks are ranked on the basis of their six-month returns. They buy the winner’s quintile and sell the loser’s quintile to calculate the momentum returns for the next 3-, 6-, 9-, and 12-month periods.

Momentum returns are measured using four different weighting schemes: equal, value, IV, and inverse IV. The authors find that IV-weighted portfolios’ returns are generally lower than those of the three other schemes.

The authors sort momentum returns into terciles by company size. They conclude that momentum is weak in hard-to-value stocks (small size and higher IV).

They also examine other Asian markets (Japan, Malaysia, Indonesia, South Korea, Hong Kong, and Singapore) and find that momentum returns of high-IV portfolios are insignificant except in South Korea.

The authors then examine market dynamics and define four market states: up/up, up/down, down/up, and down/down. They find that when momentum returns are conditioned on market dynamics, momentum returns are significantly higher when markets continue in the same state than when they transition to a different state.

Abstractor’s Viewpoint

This research is timely for active global portfolio managers because MSCI will include 222 Chinese A-shares in its index beginning in 2018. As regulations change, indexers and institutional participants may start to change the dynamic in this market, resulting in momentum strategies that deliver a better return to investors. It would be worthwhile to update and expand this research. Although the authors did not include Chinese H-shares in their sample, future research could examine these shares, which are another way to gain an alternative Chinese exposure.

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