Momentum in Australian Stock Returns: An Update

3. CONSTRUCTION OF MOMENTUM PORTFOLIOS

The construction of momentum portfolios follows closely the method described
in Jegadeesh and Titman (1993) and is also described in HP. For convenience
the salient points are repeated here:

1. Sort the stocks on the cumulative return over the past 6 months.

2. Split the sorted stocks into three groups with equal numbers of stocks.

3. Form an equal-weighted arbitrage portfolio at time t by buying the
group of best performing stocks and short-selling the group comprising
the worst performing stocks.

4. Keeping the composition of the arbitrage portfolio fixed, the returns for
holding the portfolio for one month are computed for periods {t+1,
t+2, ..., t+36}.

5. Repeat steps 1 to 4 for every time period.

In order to qualify for sorting into momentum portfolios in step 1 above,
stocks are required to satisfy two liquidity criteria. First, stocks with no
trades in the month leading to time t (current month) are automatically ruled
out. Second, all stocks with more than one missing return observation over
the 6-months momentum window are also excluded. This is different to the
procedure adopted by HP who imposed a hard size limit on stocks. The
current approach avoids the assumption that liquidity is necessarily strongly
correlated with size.

Once momentum portfolios are constructed there are three important practical
issues to deal with.

Missing return observations

The database contains a considerable number of periods when a particular
stock is not traded and hence no price record exists. HP considered three
different ways of dealing with missing data: the unconditional mean approach,
where missing values were replaced by the sample mean; the regression
approach, in which a factor model was estimated and used to produce
estimates of missing returns; and the simple approach, where any missing

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