Momentum in stocks is not only a key strategy in the many portfolios of practitioners, but it is also an attractive research topic for academics. The original idea behind momentum, is that past winner tend to perform well in the near future, and vice versa, past loser tend to underperform (Jegadeesh and Titman, 2001). Later, the momentum anomaly was found practically everywhere, Moskowitz, Ooi, and Pedersen (2012) identified momentum in an equity index, currency, commodity, and bond futures. Hartley (2020) identified momentum anomaly in global yield curves. Moreover, the momentum factor is also presented in the equity factors, as concluded by Arnott, Clements, Kalesnik and Linnainmaa (2019).
While momentum anomaly is a staple in the financial literature, the theory behind socially responsible investing or ESG investing, and mainly ESG scores is emerging. E score stands for environmental, S for social and G for governance qualities of firms. Aim of the score is to measure quality or responsibility of the firm in each of the categories mentioned above. We have also reviewed literature related to the ESG investing, and have concluded that ESG scores could be successfully used in practice, utilized in negative screening, level, or momentum strategies. It is no surprise that researchers looked for momentum in ESG scores.
What will happen if we mix ESG scoring with price momentum? Can we improve simple ESG investing strategy?
Quantpedia’s newest research paper written by Matus Padysak answers these questions. Let’s start our analysis with the following analogy – the relationship between price equity momentum and ESG scores can be compared to a robber in a jewellery store with a knapsack of limited capacity. The ESG scores and momentum anomaly can be related to the famous optimization Knapsack problem. One of the most straightforward explanations of the Knapsack problem is a robber that has limited capacity in the backpack, and naturally, wants to return from the store with a maximal loot. Therefore, the weight of the loot is limited, and robber wants to maximize his profit by choosing the most valuable combination of items that would fit into his knapsack.
The Knapsack problem applied to the equity momentum and ESG scores can form two different scenarios.
Firstly, it is possible to make classical momentum more “sustainable“ or ESG friendly. In this case, the aim is to pick stocks with the highest momentum, but at the same time, maximize the ESG score of the portfolio. In other words, the momentum represents the weight, the higher the momentum, lower the weight. The limited capacity of the knapsack ensures that only stocks with high momentum (low weight) would be included in a portfolio. The ESG score of each stock represents the value. Therefore, picking stocks with the lowest “weight“ and maximizing the “value“ creates a more ESG friendly momentum strategy.
Secondly, the situation can be reversed, and ESG can represent the “weight“ of the stock – higher the ESG, lower the weight. In this case, momentum represents the „value“ of the stock. In practice, such an approach chooses portfolio with as highest ESG as possible while maximizing the momentum of the stocks.
The first approach can be used to make the portfolio more attractive in terms of the ESG scores. The average ESG score of stocks in a portfolio can be significantly improved, with only a slight reduction in the performance. The second approach leads to a portfolio that can be without a doubt called as socially responsible according to the ESG scores. Additionally, this approach largely improves the returns of ESG strategies compared to, for example, the ESG level or momentum strategies as shown by Dorfleitner, Utz, and Wimmer (2013) and Nagy, Kassam and Lee (2016). Moreover, compared to the traditional momentum in stocks, both the volatility and maximal drawdowns are substantially improved, leading to a better risk-adjusted return compared to the momentum alone.
Visit Quantpedia to read the full article:
Disclosure: Interactive Brokers
Information posted on IBKR Traders’ Insight that is provided by third-parties and not by Interactive Brokers does NOT constitute a recommendation by Interactive Brokers that you should contract for the services of that third party. Third-party participants who contribute to IBKR Traders’ Insight are independent of Interactive Brokers and Interactive Brokers does not make any representations or warranties concerning the services offered, their past or future performance, or the accuracy of the information provided by the third party. Past performance is no guarantee of future results.
This material is from Quantpedia and is being posted with permission from Quantpedia. The views expressed in this material are solely those of the author and/or Quantpedia and IBKR is not endorsing or recommending any investment or trading discussed in the material. This material is not and should not be construed as an offer to sell or the solicitation of an offer to buy any security. To the extent that this material discusses general market activity, industry or sector trends or other broad based economic or political conditions, it should not be construed as research or investment advice. To the extent that it includes references to specific securities, commodities, currencies, or other instruments, those references do not constitute a recommendation to buy, sell or hold such security. This material does not and is not intended to take into account the particular financial conditions, investment objectives or requirements of individual customers. Before acting on this material, you should consider whether it is suitable for your particular circumstances and, as necessary, seek professional advice.