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.
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.
Is Popularity Undermining Momentum?
Steven Dolvin and Bryan Foltice, authors of the July 2016 study “Where Has the Trend Gone? An Update on Momentum Returns in the U.S. Stock Market,” sought to determine if the publication of the findings on momentum have led to a disappearing premium. They studied the performance of U.S. stocks from July 1985 to December 2015.
First, they found that their results over the full period were generally consistent with previous studies, as portfolio returns generally decrease monotonically across the portfolios formed when ranking by momentum. Furthermore, their results were highly significant.
They next looked at results over more recent subperiods, from 2007 through 2015 and from 2010 through 2015. The authors write: “In stark contrast to prior studies examining earlier period[s], we find that the subsequent 12-month risk-adjusted excess holding period returns no longer follow the clear monotonic distribution typically exhibited in prior research. In fact, we find no significant difference in average returns between the winner (P1) and loser (P10) portfolios from 2007-2015.”
Dolvin and Foltice found that, rather than exhibiting the historic monotonic increase across portfolio deciles, the “risk adjusted returns of the winner portfolio (P1) are significantly less than the middle portfolio (P5) for both recent sub-periods. 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, as ‘middle decile’ portfolios actually have experienced the highest risk adjusted returns.”
They concluded that their findings “should 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.’”
Dolvin and Foltice further conclude: “While we can only speculate at this point, there are at least two possible explanations for this shift. First, if efficiency holds, investors who identify an anomaly will trade in such a way to exploit it, thereby eliminating its impact over time. The increasing number of momentum-based mutual funds and ETFs being marketed may bear evidence to this fact. Second, the reduced efficacy of momentum in the most recent period may be due to the unusually low volatility that has persisted for the last few years. Without volatility, it is possible that momentum is unable to shine. In either case, only time (and subsequent research) will tell the final outcome, but at this point it is likely too early to conclude that momentum is dead.”
Or It Could Just Be A Lull
While it certainly is possible that the publication of research and the increase in assets engaged in momentum-based strategies has altered the nature of the premium, it’s far too early to draw any such conclusions. There are several reasons why we should be skeptical.
The first is that momentum strategies have now been well-known for more than 20 years. Did it really take well over a decade for practitioners to exploit the anomaly to the extent that it would no longer work?
Second, momentum is clearly based on behavioral explanations, including herding, anchoring, confirmation bias and the disposition effect. Because momentum has performed well historically, it’s clear that these behavioral biases have likely existed for a long time. And human behaviors tend to persist even after the biases are discovered and made well known. After all, that’s what makes us human.
Third, the authors may be placing too much emphasis on a relatively short time period. All investment factors, not just momentum, have experienced long periods of underperformance. The following table demonstrates the persistence in performance of six leading factors over the period 1927 through 2015. As you review the table, consider that Dolvin and Foltice are attempting to draw conclusions from periods shorter than 10 years.
As I am sure you noted, in the case of every single factor, including market beta, there have been periods of 10 years and longer over which a factor produced negative returns. Thus, what the authors discovered—which many others have before—is nothing more than no matter how strong the evidence, how robust the data and how strong the intuition behind a factor, all factors experience fairly long periods of negative performance. And that, in fact, is one good reason the factors are likely to persist—there are risks to each strategy and maintaining discipline over long periods is difficult for most investors, especially retail investors.
Later this week, we’ll cover more in-depth another good reason factor premiums can persist after publication even if they have behavioral explanations (there are well-known limits to arbitrage) and then discuss momentum’s post-publication returns.
Larry Swedroe is the director of research for The BAM Alliance, a community of more than 140 independent registered investment advisors throughout the country.