Investor Sentiment and Risk-Managed Factor Momentum

Abstract

This thesis studies how investor sentiment affects the performance of factor momentum. The purpose is to understand whether factor and factor momentum returns are driven by mispricing. Additionally, this thesis tests whether a target volatility—a measure of risk management—increases the performance of factor momentum portfolios. Testing the target volatility approach on factor momentum portfolios is motived by earlier studies that find benefits of risk management on price and industry momentum portfolios.

Factor momentum portfolios are constructed using a dataset of 11 U.S. equity factors. The portfolio weights for the risk-managed factor momentum are calculated using option-implied market volatility (VIX) as a proxy for the expected volatility. The overall sample period spans from July 1965 to December 2019, and from February 1990 through December 2019 for the risk-managed factor momentum portfolios. The performance of factor momentum portfolios is tested against multifactor and mispricing models.

Factor momentum portfolios that are formed with one-month lagged factor returns have statistically significant alpha against all considered asset pricing models. In contrast to previous studies, factor momentum returns are higher with a relative strength strategy than they are with a trend-following strategy. Furthermore, the results suggest that both winner- and loser-factor portfolios capture mispricing—the returns of recent winner factors are driven by positive earnings surprises while the returns of recent loser factors are driven by negative earnings surprises. Contrary to expectations, the long-minus-short factor momentum returns are not significantly affected by the contemporaneous investor sentiment. The returns of winner-factor portfolios are positively correlated with investor sentiment and significant in all sentiment stats. The returns of loser-factor portfolios are significantly positive following high investor sentiment and generally indistinguishable from zero following periods of low investor sentiment. Risk-managed factor momentum portfolios have statistically significant alpha against the unscaled portfolios.

The findings of this thesis suggest that factor and factor momentum returns are driven by mispricing that is more pronounced during periods of high investor sentiment. Betting against the recent loser factors increases the performance of factor momentum following periods of low investor sentiment but decreases the performance after periods of high investor sentiment. Buying recent winner factors is a profitable investment strategy regardless of the investor sentiment. Although factor momentum portfolios do not exhibit momentum crashes or optionality during bear market states, the performance of factor momentum portfolios can be increased using the target volatility approach and measure of option-implied market volatility.