Saturday, September 24, 2016

Strategies: Academia's Killing the Momentum Star

Or not.
Two from First up, September 19:

Why Momentum Is Struggling
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....MORE
And September 23:

Is Momentum Really Dead?
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....MORE