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FRM Part II · FRM Exam Part II · Factor Theory

An analyst builds a long-short momentum strategy by ranking stocks on their returns over the past 12 months, skipping the most recent month, going long the top decile and short the bottom decile. Which statement best explains why the most recent month is typically skipped?

The most recent month is skipped because of short-term reversal: stocks that did well in the last month tend to partly revert. Including that month would mix a reversal effect into the 12-month trend signal and dilute the momentum factor. It is a signal-construction choice, not a data or regulatory constraint.

  1. AShort-term reversal at the one-month horizon can contaminate the momentum signalCorrect
  2. BReturns in the latest month are not available from data vendors
  3. CSkipping the month raises the strategy's exposure to the value factor
  4. DMomentum is defined only over 11-month windows by regulation

Explanation

Stocks tend to show short-term reversal over about one month, meaning last month's winners often give back some return. Including that month would blend a reversal effect into the trend signal and weaken it. Data availability and regulation are not the reason, and skipping does not target value exposure.

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