Earlier this week, we examined a study that sought to determine whether the publication of academics’ findings on the momentum factor have led to a disappearing premium. To review, Steven Dolvin and Bryan Foltice, authors of the 2016 study “Where Has the Trend Gone? An Update on Momentum Returns in the U.S. Stock Market,” found that in two overlapping subperiods from their sample (both ended in 2015 and each was less than 10 years long), the risk-adjusted returns to momentum no longer followed the clear, monotonic distribution typically exhibited in prior research.
The authors write: “Thus, while a traditional strategy of going long winner stocks and short loser stocks may continue to generate positive returns, it seems that this is no longer the optimal strategy.” Dolvin and Foltice concluded their findings should in fact send “an alarming signal to both individual and institutional investors who are seeking to profit from momentum trading. In fact, maybe the new adage should be: ‘The recent trend has not been your friend.’”
While it certainly is possible that the publication of research and the increase in assets engaged in momentum-based strategies has altered the premium’s nature, I explained why it’s far too early to draw any such conclusions, and then explored several reasons why I believe investors should remain skeptical.
Today we’ll cover another reason why factor premiums can persist after publication, even if they have behavioral explanations, and then discuss momentum’s post-publication returns.
Limits To Arbitrage
In the real world, anomalies can persist because there are limits to arbitrage, such as those that make investors less likely to short undesirable securities. First, many institutional investors (like pension plans, endowments and mutual funds) are prohibited by their charters from taking short positions.
Second, the cost of borrowing a stock in order to short it can be expensive, and there can also be a limited supply of stocks available to borrow for the purpose of shorting.
Third, investors are unwilling to accept the risks of shorting because of the potential for unlimited losses. This is prospect theory at work, where the pain of a loss is much larger than the joy of an equal gain.
Fourth, short-sellers run the risk that borrowed securities are recalled before the strategy pays off. They also run the risk that the strategy performs poorly in the short run, triggering an early liquidation.
Let’s turn now to the issue of post-publication returns.
Initial research on momentum, Narasimhan Jegadeesh and Sheridan Titman’s 1993 study, “Returns to Buying Winners and Selling Losers: Implications for Stock Market Efficiency,” found that the momentum premium from 1927 through 1993 was 10.9%. In the post-publication period, from 1994 through 2015, the premium was a smaller 5.5%.
However, the following chart shows momentum first working quite well post-publication, but then suffering a huge drop in the market reversal of 2009 before again improving as equities recovered and beaten-down stocks rose dramatically.
Now let’s consider what happened in the post-2009 period. If momentum was in fact disappearing, as proposed by Dolvin and Foltice, we should have expected poor performance from 2010 through 2015. However, the Fama-French momentum factor (UMD, or up minus down) produced an annual premium of 6.8% a year and was positive in five of the six years, experiencing a single-calendar-year loss of roughly 1%. That premium is even higher than the average premium of 5.5% over the full post-publication period.
The bottom line is that it seems the rumors of the momentum factor’s “death” are premature. Yes, it does appear that publication and subsequent cash flows led to a drop in the momentum premium’s size. But a decline in size has also occurred with other factor premiums, including market beta, size and value. The premium since publication as well as following the 2009 crash has also been larger than all the other historical premiums, with the exception of market beta. And it has been both economically and statistically significant.
One conclusion investors should draw is that, given the uncertainty regarding which premiums will persist and how large they will be in the future, a prudent strategy is to diversify across the premiums that meet the criteria of being persistent, pervasive, robust, implementable and have intuitive explanations for why we should expect them to continue into the future (either risk or behavioral).
My upcoming book, “Your Complete Guide to Factor-Based Investing,” co-authored with Andrew Berkin, will present the evidence allowing you to decide which factors you want to consider. Look for the book to be available by the end of October.
The preceding discussion has focused on what is called “cross-sectional momentum.” Cross-sectional momentum measures relative performance, comparing the return of an asset to the returns of other assets within the same asset class. Thus, in a given asset class, a cross-sectional momentum strategy might buy the 30% of assets with the best relative performance and short those with the worst relative performance. Even if all the assets had risen in value, the cross-sectional momentum strategy would still short the assets with the lowest returns.
The other type of momentum is called “time-series momentum.” It is also referred to as “trend-following” because it measures the trend of an asset with respect to its own performance. Unlike cross-sectional momentum, it is an absolute-return strategy. It buys the assets that have been rising in value and shorts the assets that have been falling. In contrast to cross-sectional momentum, if all assets rise in value, then none of them would be shorted.
Larry Swedroe is the director of research for The BAM Alliance, a community of more than 140 independent registered investment advisors throughout the country.