Two of the most powerful explanatory factors in finance are value and momentum. Research on both has been published for more than 20 years. However, it was not until recently that the two have been studied in combination and across markets.
The study “Value and Momentum Everywhere” by Clifford Asness, Tobias Moskowitz and Lasse Pedersen, which appeared in the June 2013 issue of The Journal of Finance, examined the value and momentum factors across eight markets and asset classes (individual stocks in the United States, the U.K., continental Europe and Japan, as well as country equity index futures, government bonds, currencies and commodity futures). Following is a summary of their findings:
- There are significant return premiums to value and momentum in every asset class. The value premium was persistent in every stock market, with the strongest performance in Japan. The momentum premium was also positive in every market, especially in Europe, although statistically insignificant in Japan.
- Value strategies are positively correlated with other value strategies across otherwise-unrelated markets. Momentum strategies are positively correlated with other momentum strategies globally. This persistence assuages data-mining concerns.
- Value and momentum are negatively correlated with each other within and across asset classes. The negative correlation between value and momentum within each asset class is consistent and averages -0.49. For stocks alone, the correlation averaged -0.60. Value and momentum’s negative correlation and high positive expected returns implies that a simple combination of the two is much closer to the efficient frontier than either strategy alone. Combining value and momentum strategies results in improved Sharpe ratios.
- There’s significant evidence that liquidity risk is negatively related to value and positively related to momentum globally across asset classes. The implication in this case is that part of the negative correlation between value and momentum is driven by opposite-signed exposure to liquidity risk. However, liquidity risk can only explain a small fraction of the value and momentum return premiums and co-movement.
The authors offered this explanation for why momentum loads positively on liquidity risk and value loads negatively: “A simple and natural story might be that momentum represents the most popular trades, as investors chase returns and flock to the assets whose prices appreciated most recently. Value, on the other hand, represents a contrarian view. When a liquidity shock occurs, investors engaged in liquidating sell-offs (due to cash needs and risk management) will put more price pressure on the most popular and crowded trades, such as high momentum securities, as everyone runs for the exit at the same time, while the less crowded contrarian/value trades will be less affected.”