Swedroe: Explaining Momentum Factors

Momentum-focused strategies make sense when you separate upside and downside risks, Swedroe says.

Since the publication of the study “Returns to Buying Winners and Selling Losers: Implications for Stock Market Efficiency” in 1993, the momentum anomaly—buying past winners and selling past losers, generates abnormal returns in the short run—has received a lot of attention.

This anomaly presents perhaps the greatest challenge to market efficiency, because it could not be explained by conventional risk measures such as standard deviation and the market beta.

Since the publication of that study in the Journal of Finance in 1993, there has been a great amount of research on momentum. Summarizing, subsequent research has found that momentum’s existence is both persistent and pervasive—it exists not only in individual stocks around the globe, but also at the level of national equity markets, in currencies, commodities and bonds. The phenomenon remained an anomaly because there was no risk-based explanation—at least not until Victoria Dobrynskaya’s 2014 paper “Asymmetric Risks of Momentum Strategies.”

Dobrynskaya’s study provides a risk-based explanation for the profitability of global momentum by demonstrating that the performance of past winners has higher downside market betas and lower upside market betas than losers.

Investors demand large premiums for assets that do poorly in bad times when the marginal utility of wealth is high and asset returns are particularly important. Assets with high relative upside betas, on the contrary, do not require a high risk premium, because the marginal utility of wealth is low in such states.

Dobrynskaya cited prior research from several studies that demonstrated the importance of separating the overall market risk into the upside and downside risks for asset pricing. Together with her paper the research provides “convincing evidence that the models with downside risk (e.g., a two-beta CAPMl) have greater explanatory power in the stock, currency, commodity, and bond markets. They show that the downside risk is a unifying explanation for returns in different asset markets.”

She added that her study showed that “the downside risk alone does not fully explain the returns to the cross-section of momentum portfolios because the upside risk plays a significant role too.”

Dobrynskaya’s study covered the period November 1990 to August 2013 and 23 individual countries. The countries were broken into three regions: The European portfolios consist of stocks from 16 countries; the Asian-Pacific portfolios consist of stocks from four countries; and the North-American portfolios consist of stocks from Canada and the U.S. She also studied the global portfolio. The following is a summary of her findings:

• For any set of momentum portfolios considered, the asymmetry in betas is monotonically increasing from losers to winners and it is statistically significant.
• The momentum portfolios are profitable in all regions, with the highest momentum return in Europe (17.6 percent p.a.) and the lowest momentum return in the Asian-Pacific region (6.6 percent p.a.).
• Past losers have higher upside betas than downside betas, whereas past winners have higher downside betas than upside betas. Thus, the winner-minus-loser momentum portfolios are exposed to the downside risk, but hedge against the upside risk. In other words, the momentum portfolios perform badly in states of global market upturns—momentum portfolios crash when the market rebounds after a market decline, and when the market return is high.
• The relative downside beta, which captures the extra downside risk and, hence, the downside-upside risk asymmetry, explains the returns to the momentum portfolios well, whereas the traditional beta has no explanatory power.
• The relative downside beta premium is approximately 2 percent per month, highly statistically significant, similar in magnitude to the estimates obtained for the stock and currency markets, and economically meaningful.
• Small-winner stocks have the highest downside risk, the lowest upside risk and the greatest downside-upside risk asymmetry. Big loser stocks have the lowest downside risk, the highest upside risk and the lowest (negative) risk asymmetry.
• The two-beta factor model adds explanatory power to the cross section of expected returns.

Summary

There is a large body of research demonstrating that momentum strategies generate high returns. This evidence created the greatest challenge to market efficiency because it lacked a risk-based explanation. Using a two-beta model, separating the market into upside and downside risks, the evidence presented provides the missing explanation. In Dobrynskaya’s words:

“Momentum strategies appear to have asymmetric risk profile: They are exposed to the downside risk, but hedge against the upside risk. Since the upside and downside risks are priced differently, the momentum return is a compensation for this risk asymmetry.”

Larry Swedroe is director of Research for the BAM Alliance, a community of more than 130 independent registered investment advisors throughout the country.