Robeco, The Investments Engineers
blue circle

06-09-2021 · インサイト

Momentum is a self-fulfilling prophecy and therein lies its strength

The Momentum premium arises from mistakes in human reasoning. Despite being conceptually simple and publicly known, it remains a strong factor across numerous asset classes. Behavioral finance theories shed light on why it exists and why it has not been arbitraged away.

    執筆者

  • Lusanele Magwa - Quant Investment Specialist/CPM

    Lusanele Magwa

    Quant Investment Specialist/CPM

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

Figure 1 | Historical performance of equity factor premiums

Figure 1 | Historical performance of equity factor premiums

Source: Data library of Professor Kenneth French, Robeco. All factors are long-only portfolios of US stocks that are invested 50% in big and 50% in small top factor portfolio based on 2x3 size-factor sorts from Professor Kenneth French. The low volatility factor is constructed in the same way, but is obtained from Robeco.com/data. Quality is an equal-weight combination of operating profitability and investment portfolios of Professor Kenneth French. Sample runs from January 1930 till December of 2019 for all factors but quality, which starts in July of 1963.

To understand why momentum investing has performed so well and not been arbitraged away, one needs to understand why this phenomenon exists in the first place.

Risk-based theories fall short in their explanations

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

Behavioral biases give rise to Momentum premium

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.

Why hasn’t Momentum been arbitraged away?

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.

Humans consistently make errors, even when they have been previously informed of them

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.

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.

Footnotes

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.

重要事項

当資料は情報提供を目的として、Robeco Institutional Asset Management B.V.が作成した英文資料、もしくはその英文資料をロベコ・ジャパン株式会社が翻訳したものです。資料中の個別の金融商品の売買の勧誘や推奨等を目的とするものではありません。記載された情報は十分信頼できるものであると考えておりますが、その正確性、完全性を保証するものではありません。意見や見通しはあくまで作成日における弊社の判断に基づくものであり、今後予告なしに変更されることがあります。運用状況、市場動向、意見等は、過去の一時点あるいは過去の一定期間についてのものであり、過去の実績は将来の運用成果を保証または示唆するものではありません。また、記載された投資方針・戦略等は全ての投資家の皆様に適合するとは限りません。当資料は法律、税務、会計面での助言の提供を意図するものではありません。 ご契約に際しては、必要に応じ専門家にご相談の上、最終的なご判断はお客様ご自身でなさるようお願い致します。 運用を行う資産の評価額は、組入有価証券等の価格、金融市場の相場や金利等の変動、及び組入有価証券の発行体の財務状況による信用力等の影響を受けて変動します。また、外貨建資産に投資する場合は為替変動の影響も受けます。運用によって生じた損益は、全て投資家の皆様に帰属します。したがって投資元本や一定の運用成果が保証されているものではなく、投資元本を上回る損失を被ることがあります。弊社が行う金融商品取引業に係る手数料または報酬は、締結される契約の種類や契約資産額により異なるため、当資料において記載せず別途ご提示させて頂く場合があります。具体的な手数料または報酬の金額・計算方法につきましては弊社担当者へお問合せください。 当資料及び記載されている情報、商品に関する権利は弊社に帰属します。したがって、弊社の書面による同意なくしてその全部もしくは一部を複製またはその他の方法で配布することはご遠慮ください。 商号等: ロベコ・ジャパン株式会社  金融商品取引業者 関東財務局長(金商)第2780号 加入協会: 一般社団法人 日本投資顧問業協会