Swedroe: Why Momentum Is Struggling

September 19, 2016

Momentum is the tendency for assets that have performed well (poorly) in the recent past to continue to perform well (poorly) in the future, at least for a short period of time. Mark Carhart, in his 1997 study “On Persistence in Mutual Fund Performance,” was the first to use momentum, together with the three Fama-French factors (market beta, size and value), to explain mutual fund returns. Initial research on momentum, however, was published by Narasimhan Jegadeesh and Sheridan Titman, authors of the 1993 study “Returns to Buying Winners and Selling Losers: Implications for Stock Market Efficiency.”

The research on momentum has shown that its premium has been persistent across long periods of time, pervasive across geography and asset classes (stocks, bonds, commodities and currencies), robust to various definitions (formation periods) and implementable (as it survives transaction costs).

With this is mind, it has also been firmly established that the publication of academic research can impact the performance of investment factors shown to have premiums. The reasons are intuitive.

Research’s Impact
First, if anomalies are the result of behavioral mistakes, or even if they are the result of investor preferences, and publication draws the attention of sophisticated investors, it is possible that post-publication arbitrage would cause their premiums to disappear. Investors who seek to capture the identified premiums could move prices in a manner that reduces the return spread between assets with high and low factor exposure.

However, limits to arbitrage, such as aversion to shorting and its high cost, can prevent arbitrageurs from correcting pricing mistakes. And the research shows that this tends to be the case when mispricings exist in less liquid stocks where trading costs are high. More on this subject soon.

Second, even if the premium is fully explained by economic risks, as more cash flows into the funds acting to capture the premium, the size of the premium will be affected. At first, publication will trigger inflows of capital, which drives prices higher and thus generates higher returns. However, these higher returns are temporary, because subsequent future returns will be lower.

In fact, academic research has found that, on average, factor premiums shrink post-publication by about one-third. The research has also found factor-based portfolios containing stocks that are costlier to arbitrage decline less post-publication.

This is consistent with the idea that costs limit arbitrage and protect mispricing, because decay—as opposed to disappearance—will occur if frictions prevent arbitrageurs from fully eliminating mispricing. In addition, research has found that strategies concentrated in stocks that are costly to arbitrage have higher expected returns post-publication.    


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