- A new paper discusses the facts and the myths surrounding the momentum factor.
- The momentum premium has been evident in U.S. equity data for over 200 years.
- The momentum premium has been both persistent over time and pervasive across countries, geographic regions, and asset classes.
Today begins a two-part series on momentum and the myths that surround it. Momentum is the phenomenon that explains how securities, which have performed well relative to peers (winners), on average, continue to outperform, and securities, that have performed relatively poorly (losers), tend to continue to underperform. Jegadeesh and Titman are credited with the first academic paper on the subject. Their study, "Returns to Buying Winners and Selling Losers: Implications for Stock Market Efficiency," was published in the March 1993 issue of the Journal of Finance. Twenty years later we have evidence not only of momentum's existence in stock returns, but evidence that the momentum premium has been both persistent over time and pervasive across countries, geographic regions, and asset classes (such as commodities, bonds, and currencies). In fact, Clifford S. Asness, Andrea Frazzini, Ronen Israel, and Tobias J. Moskowitz, authors of the May 2014 paper, "Fact, Fiction and Momentum Investing" note that the momentum premium "is evident in 212 years (1801 to 2012) of U.S. equity data, dating back to the Victorian age in U.K. equity data, in over 20 years of out-of-sample evidence from its original discovery, in 40 other countries, and in more than a dozen other asset classes."
Despite the depth and breadth of the evidence, the authors' note that "as momentum strategies have grown in popularity, so have myths around them." Their paper addresses 10 of these myths. Today, we'll look at the first five.
Myth #1: Momentum returns are too small and sporadic
From 1927 through 2013, the momentum premium was the largest of the four premiums (beta, size, value, and momentum) at 8.3 percent per annum, and it had the highest Sharpe ratio at 0.5. However, it's worth pointing out that since 1991 the momentum premium and its Sharpe ratio have declined somewhat, falling to 6.3 percent and 0.36, respectively. This shouldn't come as a total surprise as there's evidence that post publication, return premiums tend to shrink. And the same thing has happened to the value premium. From 1927-2013 the value premium and Sharpe ratio were 4.7 percent and 0.39 percent, respectively. From 1991-2013 those figures fell to 3.6 percent and 0.32, respectively.
As to persistency, at the one-year level the momentum premium has been the most persistent of the four premiums at 81 percent, and even since 1991 it's persistence was 76 percent, just below that of the equity risk premium, but higher than for the value and size premium. At the five-year level, the momentum premium was the highest at 88 percent, and since 1991 its persistence (71 percent) was very similar to that of the persistence of the other premiums which ranged from 73 percent to 75 percent.
The bottom line is that it's hard to make the claim that the momentum premium has either been small or sporadic.
Myth #2: Momentum cannot be captured by long-only investors as momentum can only be exploited on the short side.
Like all premiums, momentum is a long-short portfolio; long the winners and short the losers. With that said, the historical data is that slightly more than half (52 percent) of the U.S. momentum premium in stocks actually comes from the long side. The authors also noted that their research found no evidence that the short side dominated the momentum premium in either international markets or any of the five asset classes they looked at.
The bottom line is that momentum works equally well on the long side as it does on the short side.
Myth #3: Momentum is much stronger among small cap stocks than large caps
While there is some evidence that the momentum premium is stronger in small caps, there's still a big momentum premium in large caps. From 1927 through 2013 the U.S. momentum premium was 9.8 percent per year in small stocks and 6.8 percent per year in large caps - and both are highly statistically significant. The international data is similar.
Myth #4: Momentum does not survive, or is seriously limited by, trading costs
To discredit this myth the authors cite the 2013 study, "Trading Costs of Asset Pricing Anomalies." Using a unique dataset containing more than a trillion dollars of live trades of an institutional investor from 1998 to 2013 across 19 developed equity markets, the authors estimated what real-world trading costs are for momentum, value, and size-based strategies. Their conclusion is that per dollar trading costs for momentum are quite low, and thus, despite the higher turnover, momentum easily survives transactions costs.
The authors' note that the myth arises because "most academic studies examine portfolios that do not consider transactions costs in their design and do not allow for tradeoffs that could lead to a reduction in trading costs. They simply rebalance as automatons ignoring costs. Trading patiently (by breaking orders up into small sizes and setting limit order prices that provide, not demand, liquidity) and allowing some tracking error to a theoretical-style portfolio can significantly reduce trading costs without changing the nature of the strategy."
Myth #5: Momentum does not work for a taxable investor
They cite the academic literature which demonstrates that "momentum, despite having five to six times the annual turnover as value, actually has a similar tax burden as value." The reasons are that "momentum actually has turnover that is biased to be tax advantageous-it tends to hold on to winners and sell losers-thus avoiding realizing short-term capital gains in favor of long-term capital gains and realizing short-term capital losses. From a tax perspective this is efficient and effectively lowers the tax burden of momentum strategies." They also note that "since the premium for momentum is quite a bit higher than for value, yet they face similar tax rates, the after-tax returns to momentum are also higher than for value." They further note that smart tax strategies (delaying sales that realize short-term gains until they become long term can often be a matter of only a month) can enhance after-tax returns without materially impacting the portfolio's pre-tax return.
Tomorrow, we'll conclude with five more myths.