Information Ratios Reveal Drift and Autocorrelation in Momentum

Summary

This study uses information ratio (average return relative to volatility) to examine how momentum performance changes with the portfolio look-back period. It derives theoretical information ratios under two possible sources of momentum: positive return autocorrelation and average-return drift. The analysis suggests that shorter, several-month look-backs are more sensitive to autocorrelation, while periods nearer a year are more likely to reflect drift.

The authors compare these theoretical patterns with historical data by dividing it into stationary periods. They find that autocorrelation is more important in some regimes, particularly before 1975, while drift explains more in many later periods. Applying the strategy to more than a century of Dow Jones Industrial Average data, they also report damped information-ratio oscillations over multi-year look-backs, which they model as reversals toward the mean growth rate. The findings describe historical relationships and theoretical mechanisms; they do not establish that one look-back performs best in future markets or account for implementation costs.

Key ideas

• The information ratio varies with look-back length and with the mechanism producing momentum.
• Shorter look-backs can capture return autocorrelation, while longer periods nearer a year can reflect average-return drift.
• Historical regimes differ in the relative importance of autocorrelation and drift.
• Long-run Dow Jones data show damped information-ratio oscillations that the authors model as reversion toward mean growth.

Tags

# Information ratio analysis of momentum strategies


# Information ratio analysis of momentum strategies









In the past 20 years, momentum or trend following strategies have become an established part of the investor toolbox. We introduce a new way of analyzing momentum strategies by looking at the information ratio (IR, average return divided by standard deviation). We calculate the theoretical IR of a momentum strategy, and show that if momentum is mainly due to the positive autocorrelation in returns, IR as a function of the portfolio formation period (look-back) is very different from momentum due to the drift (average return). The IR shows that for look-back periods of a few months, the investor is more likely to tap into autocorrelation. However, for look-back periods closer to 1 year, the investor is more likely to tap into the drift. We compare the historical data to the theoretical IR by constructing stationary periods. The empirical study finds that there are periods/regimes where the autocorrelation is more important than the drift in explaining the IR (particularly pre-1975) and others where the drift is more important (mostly after 1975). We conclude our study by applying our momentum strategy to 100 plus years of the Dow-Jones Industrial Average. We report damped oscillations on the IR for look-back periods of several years and model such oscilations as a reversal to the mean growth rate.

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