Swedroe: The Downside Of Momentum

March 01, 2017

Momentum has been found to be a persistent and pervasive factor in the returns not only of equities, but in other asset classes (including bonds, commodities and currencies). With equities (compared to the market, value, size, profitability and quality factors), during the period 1927 through 2015, momentum has earned both the highest premium (9.6%) and the highest Sharpe ratio (0.61). However, momentum has also had the worst crashes, making the strategy unappealing to investors with strong risk aversion.

Crash And Burn
Kent Daniel and Tobias Moskowitz contribute to the literature on momentum with their paper, “Momentum Crashes,” which covers the period 1927 through 2013 and appears in the November 2016 issue of the Journal of Financial Economics.

They found that “despite their strong positive average returns across numerous asset classes, momentum strategies can experience infrequent and persistent strings of negative returns.” Thus, such strategies exhibit negative skewness, a feature generally disliked by investors (and which should thus require a large premium).

For example, they found that “the two worst months for a momentum strategy that buys the top decile of past 12-month winners and shorts the bottom decile of losers are consecutive: July and August of 1932. Over this short period, the past-loser decile portfolio returned 232%, while the past-winner decile portfolio had a gain of only 32%. In a more recent crash, over the three-month period from March to May of 2009, the past-loser decile rose by 163%, while the decile portfolio of past winners gained only 8%.”

The good news was that the authors also found that these momentum crashes are partly forecastable. They occur in “panic” states (which follow market declines and occur when market volatility is high) and are contemporaneous with market rebounds. Daniel and Moskowitz show that “the low ex-ante expected returns in panic states are consistent with a conditionally high premium attached to the option-like payoffs of past losers.”

They also show that “an implementable dynamic momentum strategy based on forecasts of momentum’s mean and variance approximately doubles the alpha and Sharpe Ratio of a static momentum strategy, and is not explained by other factors. These results are robust across multiple time periods, international equity markets, and other asset classes.”


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