As a concept, momentum investing is simple: buy (overweight) assets that have recently outperformed their peers and sell (underweight) those that have underperformed. Despite the relative simplicity of this investment approach, the factor has been able to generate strong long-term performance in equity markets.
This is illustrated in Figure 1, which shows the 10-year returns of various factors since the 1930s. We have seen that momentum has delivered the highest gross returns in five out of nine decades and beat the market in all nine. Moreover, recent evidence indicates that it continues to be one of the strongest factors and that it has not been arbitraged away.1
According to the neoclassical school of thought, the momentum premium is compensation for bearing some systematic risk. In practice, momentum is a fast-changing factor and the stocks it favors can change substantially from one month to the next. Therefore, from a risk-based perspective, the premium could stem either from the constant change in financial market risks or shifts in how much risk investors are willing to bear. However, real-world evidence suggests these components actually change slowly.
Another risk-based explanation is that the momentum premium could arise from investors expecting to be compensated for potential crash risk. Indeed, it is known that momentum strategies can suffer from sudden and devastating crashes, such as the one that occurred in 2009. However, research shows that risk-managed momentum strategies which do not exhibit crashes also have the potential to generate high returns for investors, clearly contradicting this theory.2
In acknowledgement of the lack of adequate risk-based explanations, even the father of the efficient market hypothesis, Eugene Fama, referred to momentum as the biggest challenge to his theory.
Behavioral finance has been more successful at explaining the existence of the momentum factor
Where neoclassical, risk-based theories have failed, behavioral finance has been more successful at explaining the existence of the momentum factor. Unlike in mainstream, neoclassical finance, where investors are considered to be ‘rational’ agents that understand risks and opportunities in financial markets, behavioral finance builds on the assumption that investors are not fully rational and they make decisions based on heuristics, which can lead to mistakes and therefore ‘anomalies’.
The overconfidence investors have in their ability to analyze securities, and tendency to attribute success to skill and failure to bad luck, can help explain the existence of momentum. For instance, if positive newsflow emerges that affirms the views of private investors, they will tend to push the stock price of the related company above its fundamental value i.e., over-extrapolate. But this is eventually rectified when fresh newsflow highlights the overreaction of the investors, typically leading to a long-term correction in the stock price.
Underreaction can also contribute to a momentum premium. This is based on the conservatism bias that implies investors tend to change their beliefs slowly.3 In this scenario, the bias would restrain a firm’s stock price from initially adjusting adequately in response to newsflow. But this underreaction can instigate momentum as the price moves slowly towards its correct (fundamental) value, due to the good news being taken into account progressively.
The psychology of overreaction and underreaction was conceptualized in a unified manner, in a 1999 academic paper.4 The researchers developed a model with two types of investors with different information: news watchers who determine the value of a firm based on fundamental news, and momentum traders who extrapolate patterns from historical price changes.
If positive newsflow is disseminated about a firm's fundamental value, the news watchers would trade on it first. They found this would lead to an insufficient increase in its stock price as the news would spread slowly in the market i.e., underreaction. The momentum traders would then extrapolate this trend only after observing the initial uptick in the price, resulting in an overreaction. As in the other cases of overreaction, a long-term correction would then follow.
If momentum-linked anomalies have delivered robust returns on the back of mistakes in human reasoning, the natural question is why have they not been arbitraged away.
Firstly, momentum is not an easy factor to harvest. Unlike value, for instance, which can be implemented with a modest turnover of 10-20% per year, the traditional momentum factor typically has a turnover of a several hundred percentage points a year. Clearly, in order to effectively harvest this factor after costs, one needs to apply smart trading strategies.
Secondly, while the momentum premium has been linked to behavioral biases as opposed to risk, exploiting it may not be completely painless. Momentum strategies have been shown to be prone to rare but severe crashes. Therefore, momentum investors also need to be able to commit their capital over a longer-term period and be ready to face challenging times.
Thirdly, there is no one correct way to define momentum. Even simple price momentum is often defined using different lookback periods, ranging from three to twelve months. Also, an investor can choose to implement one version of momentum or to combine multiple factors such as residual momentum or connected analyst momentum.
Humans consistently make errors, even when they have been previously informed of them
Lastly, human psychology and our propensity to make cognitive mistakes should not be underestimated. Much of the experimental work in finance shows that humans consistently make errors, even when they have been previously informed of them. One does not need to dig deep to find examples of over-extrapolative markets, fueled by human enthusiasm. Time and time again, these patterns emerge and lead to predictable patterns that only systematic and patient investors may be able to exploit.
In the next paper of this series, we will discuss the low volatility factor through a behavioral finance lens.
1Please see: Blitz, D.C., May 2021, “The Quant Crisis of 2018:2020: Cornered by Big Growth”, Journal of Portfolio Management.
2Barroso P., and Santa-Clara P., April 2015, “Momentum has its moments”, Journal of Financial Economics.
3Daniel, K., Hirshleifer, D., and Subrahmanyam, A., December 1998, “Investor psychology and security market under- and overreactions“, Journal of Finance.
4Hong, H., and Stein, J. C., December 1999, “A unified theory of underreaction, momentum trading, and overreaction in asset markets“, Journal of Finance.
The contents of this document have not been reviewed by the Securities and Futures Commission ("SFC") in Hong Kong. If you are in any doubt about any of the contents of this document, you should obtain independent professional advice. This document has been distributed by Robeco Hong Kong Limited (‘Robeco’). Robeco is regulated by the SFC in Hong Kong.
This document has been prepared on a confidential basis solely for the recipient and is for information purposes only. Any reproduction or distribution of this documentation, in whole or in part, or the disclosure of its contents, without the prior written consent of Robeco, is prohibited. By accepting this documentation, the recipient agrees to the foregoing
This document is intended to provide the reader with information on Robeco’s specific capabilities, but does not constitute a recommendation to buy or sell certain securities or investment products. Investment decisions should only be based on the relevant prospectus and on thorough financial, fiscal and legal advice. Please refer to the relevant offering documents for details including the risk factors before making any investment decisions.
The contents of this document are based upon sources of information believed to be reliable. This document is not intended for distribution to or use by any person or entity in any jurisdiction or country where such distribution or use would be contrary to local law or regulation.
Investment Involves risks. Historical returns are provided for illustrative purposes only and do not necessarily reflect Robeco’s expectations for the future. The value of your investments may fluctuate. Past performance is no indication of current or future performance.
Please read this information carefully.
This website is prepared and issued by Robeco Hong Kong Limited ("Robeco"), which is a corporation licensed by the Securities and Futures Commission in Hong Kong to engage in Type 1 (dealing in securities); Type 4 (advising in securities) and Type 9 (asset management) regulated activities. The Company does not hold client assets and is subject to the licensing condition that it shall seek the SFC’s prior approval before extending services at retail level. This website has not been reviewed by the Securities and Futures Commission or any regulatory authority in Hong Kong.
2. Important risk disclosures
2. Important risk disclosures Robeco Capital Growth Funds (“the Funds”) are distinguished by their respective specific investment policies or any other specific features. Please read carefully for the risks of the Funds:
3. Local legal and sales restrictions
The information contained in the Website is being provided for information purposes.
Neither information nor any opinion expressed on the Website constitutes a solicitation, an offer or a recommendation to buy, sell or dispose of any investment, to engage in any other transaction or to provide any investment advice or service. The information contained in the Website does not constitute investment advice or a recommendation and was prepared without regard to the specific objectives, financial situation or needs of any particular person who may receive it. An investment in a Robeco product should only be made after reading the related legal documents such as management regulations, prospectuses, most recent annual and semi-annual reports, which can be all be obtained free of charge at www.robeco.com/hk/en and at the Robeco Hong Kong office.
4. Use of the Website
The information is based on certain assumptions, information and conditions applicable at a certain time and may be subject to change at any time without notice. Robeco aims to provide accurate, complete and up-to-date information, obtained from sources of information believed to be reliable. Persons accessing the Website are responsible for their choice and use of the information.
5. Investment performance
No assurance can be given that the investment objective of any investment products will be achieved. No representation or promise as to the performance of any investment products or the return on an investment is made. The value of your investments may fluctuate. The value of the assets of Robeco investment products may also fluctuate as a result of the investment policy and/or the developments on the financial markets. Results obtained in the past are no guarantee for the future. Past performance, projection, or forecast included in this Website should not be taken as an indication or guarantee of future performance, and no representation or warranty, express or implied, is made regarding future performance. Fund performance figures are based on the month-end trading prices and are calculated on a total return basis with dividends reinvested. Return figures versus the benchmark show the investment management result before management and/or performance fees; the fund returns are with dividends reinvested and based on net asset values with prices and exchange rates of the valuation moment of the benchmark.
Investments involve risks. Past performance is not a guide to future performance. Potential investors should read the terms and conditions contained in the relevant offering documents and in particular the investment policies and the risk factors before any investment decision is made. Investors should ensure they fully understand the risks associated with the fund and should also consider their own investment objective and risk tolerance level. Investors are reminded that the value and income (if any) from shares of the fund may be volatile and could change substantially within a short period of time, and investors may not get back the amount they have invested in the fund. If in doubt, please seek independent financial and professional advice.
6. Third party websites
This website includes material from third parties or links to websites maintained by third parties some of which is supplied by companies that are not affiliated to Robeco. Following links to any other off-site pages or websites of third parties shall be at the own risk of the person following such link. Robeco has not reviewed any of the websites linked to or referred to by the Website and does not endorse or accept any responsibility for their content nor the products, services or other items offered through them. Robeco shall have no liability for any losses or damages arising from the use of or reliance on the information contained on websites of third parties, including, without limitation, any loss of profit or any other direct or indirect damage. Third party off-site pages or websites are provided for informational purposes only.
7. Limitation of liability
Robeco as well as (possible) other suppliers of information to the Website accept no responsibility for the contents of the Website or the information or recommendations contained herein, which moreover may be changed without notice.
Robeco assumes no responsibility for ensuring, and makes no warranty, that the functioning of the Website will be uninterrupted or error-free. Robeco assumes no responsibility for the consequences of e-mail messages regarding a Robeco (transaction) service, which either cannot be received or sent, are damaged, received or sent incorrectly, or not received or sent on time.
Neither will Robeco be liable for any loss or damage that may result from access to and use of the Website.
8. Intellectual property
All copyrights, patents, intellectual and other property, and licenses regarding the information on the Website are held and obtained by Robeco. These rights will not be passed to persons accessing this information.
10. Applicable law
The Website shall be governed by and construed in accordance with the laws of Hong Kong. All disputes arising out of or in connection with the Website shall be submitted to the exclusive jurisdiction of the courts of Hong Kong.