The most important anomaly, and the biggest threat to the efficient markets hypothesis, is momentum—the tendency of assets with good recent performance to continue overperforming in the near future.
Momentum has been well documented globally and across a wide spectrum of assets. It’s viewed as an anomaly because there is no good risk story, no standard asset pricing model to explain it. Thus, we are left with behavioral explanations such as investors reacting slowly or irrationally to information.
Dimitri Vayanos and Paul Woolley, authors of the study “An Institutional Theory of Momentum and Reversal,” published in the May 2013 issue of The Review of Financial Studies, provide an explanation that is based on “rational agents.”
They begin with the assumption that “investors delegate the management of their portfolios to financial institutions, such as mutual funds and hedge funds.” Their explanation then emphasizes the role of fund flows as follows.
“Suppose that a negative shock hits the fundamental value of some assets. Investment funds holding these assets realize low returns, triggering outflows by investors who update negatively about the ability of the managers running these funds.
“As a consequence of the outflows, funds sell assets they own, and this depresses further the prices of the assets hit by the original shock. If, in addition, outflows are gradual because of institutional constraints (e.g., lock-up periods, institutional decision lags), the selling pressure causes prices to decrease gradually, leading to momentum.”
They go on to note that eventually the outflows push prices below fundamental values, expected returns rise, leading to an eventual reversal—assets that performed well over a long period tend to subsequently underperform. They explain that reversals are closely related to the value effect—the ratio of a company’s stock price to its earnings or its book-to-market value is negatively related to subsequent performance. Relatively cheap securities, value or low-priced stocks earn higher returns than expensive securities such as growth stocks.
This explanation for momentum is consistent with findings from other academic papers. For example, recent research has found that:
- Mutual funds experiencing large outflows engage in distressed selling of their stock portfolios.
- Co-movement between stocks is larger when these are held by many mutual funds in common, controlling for style characteristics.
- Flows into stocks can explain up to 50 percent of stock-level momentum, especially for large stocks.
They authors concluded: “In focusing on flows between investment funds as a driver of momentum, we do not intend to suggest that they are the only driver. Indeed, momentum could be also generated by gradual and anticipated changes in leverage or irrational sentiment. At the same time, flows between investment funds seem to be a relevant driver of momentum.”
Larry Swedroe is director of Research for the BAM Alliance, which is part of St. Louis-based Buckingham Asset Management.
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