Active Momentum Trading versus Passive '1/N Naive Diversification'

Abstract

We consider a passive 1/N naive diversification strategy which is long in the equally weighted portfolio of stocks feasible for trading and short in the risk-free asset. We then examine the profi tability, exposures to risk factors, idiosyncratic variance as well as the relation between the momentum and the 1/N naive diversifi cation strategies. The set of sample stocks that we use to construct the equally weighted portfolio is the same as that for constructing the momentum strategies. We fi nd that both strategies generate an average pro t of 1% per month. The differences in raw and risk-adjusted pro ts between these two strategies are statistically and economically insignifi cant. These two strategies are independent of each other. The idiosyncratic variance of the momentum strategies is 20 times higher than that of the naive diversifi cation strategy. The findings are consistent over the period between 1926 and 2005 and various sub-sample periods including the periods examined in Jegadeesh and Titman (1993 and 2001) and in our simulations where we randomly select 10 years for 100 times. The results also hold when we conduct tests in sub-samples where we divide the sample, each month, into two groups of large and small size stocks.