Monday, August 25, 2014

Anomalies: Can Momentum Be Arbitraged Away?

Probably not.
From Systematic Relative Strength:
Will momentum “work” in the future just because it did in the past?  Or, is momentum susceptible to having its returns arbitraged away?  Valid question, and one that comes up regularly.

First, just a quick review of how momentum has performed in the past.  There are a number of white papers on this topic, but results of a white paper by RBC Capital Markets are summarized below:
exhibit 1 Can Momentum Be Arbitraged Away?
Over this period of time, momentum outperformed in every single decade.  It also outperformed the S&P 500 by 3.7% annually over the test period.  This is just an academic formulation of momentum and there are other formulations that may be better or worse, but the conclusion is pretty clear: momentum is a very robust return factor.

I think there are two key reasons why momentum returns have not been arbitraged away up to this point and why they are unlikely to be arbitraged away in the future.

First, as long as there is momentum in the underlying fundamentals of companies, there will be price momentum in stocks.

Consider, the strong momentum of revenue of Microsoft (MSFT) in the 1990′s.  I only had revenue data going back to mid-1994, but the explosive growth is very clear.
msft1 Can Momentum Be Arbitraged Away?
Source: FactSet, June 1994 – December 1999, Trailing 12 month revenue for each quarter
Just as there was momentum in the underlying fundamentals of the company, there was also strong price momentum in the stock during the 1990′s.  In fact, MSFT outperformed the S&P 500 nine out of ten years in the 1990′s....
...Second, there is a behavioral explanation for momentum that I don’t believe is likely to go away.  This is summarized by Andrew Ang in his book Asset Management: A Systematic Approach to Factor Investing.....

HT: Abnormal Returns