Abstract: It is documented in the literature that the momentum and reversal effects are very prevalent in both oversea and China stock market. However, Chinese investors cannot implement the well-known momentum/reversal strategy directly to make profit due to various trading restrictions. A momentum factor tracking strategy is proposed that minimizes the variance of the difference in returns between a target portfolio and momentum factor. The momentum factor tracking model is established and solved, and the properties of the optimal portfolio are analyzed. It is found that the optimal momentum factor tracking portfolio satisfies two-fund-separation theorem, in which the two funds are momentum factor mimicking portfolio and minimum-variance portfolio determined in the traditional mean-variance model. Using ten industry indices of HS300 as risky assets in the investment universe, the performance for various momentum factor tracking portfolios is investigated and is compared with that of equally weighted portfolio (EWP) and minimum-variance portfolio (MVP). The results show that, momentum factor tracking portfolios outperform EWP and MVP, measured by expected excess return, Sharpe ratio and net Sharpe ratio. The superior performance of the momentum factor tracking portfolios are attributed to these portfolios’ ability to capture the momentum or reversal effect in stock market. To a large extent, the effectiveness of momentum factor tracking strategy is justified so that the strategy can act as a reference for asset allocation in China stock market.

Key words: factor tracking; momentum; portfolio performance; China stock market