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1 February 2012 CFA Institute Journal Review

Momentum in Japan: The Exception That Proves the Rule (Digest Summary)

  1. Paras Gupta

The author studies the “failure” of the momentum strategy in Japan. He finds that the failure, which occurred only in Japan, does not prove that momentum strategies are ineffective. Rather, momentum strategies combined with the value effect are powerful across the globe, including in Japan.

Various studies conducted during the early to mid-1990s have documented that the success of momentum strategies is one of the strongest empirical regularities in finance. Momentum has joined size and value as one of the main risk factors in modern investing. The author notes that both momentum and value have shown consistent out-of-sample success when tested across geography, asset class, security type, and time. One notable exception, however, has been the empirical failure of momentum for stock selection in Japan.

The author examines the failure of momentum in Japan and seeks to discover whether this exception actually proves the rule or exposes momentum strategies as being flawed. He also argues that value and momentum have a negative correlation and must be viewed together as a system as well as studied together.

The author uses international equity returns from Datastream aggregated across four regions: the United States, the United Kingdom, Europe (ex United Kingdom), and Japan. The data cover the period from July 1981 to December 2010, from which value and momentum portfolios are obtained for each of the four regions. Eight data series are created: the returns of a large-capitalization, liquid, dollar-balanced, and long–short value strategy for each of the four regions and the returns of a similarly constructed momentum strategy for each of the four regions.

From an empirical analysis of the data series, the author obtains results of the value and momentum strategies for each of the four regions and for an “All” region that invests an equal dollar amount in all four regions. For each region, he reports the average annualized returns, annualized standard deviations, Sharpe ratios, and t-statistics for both strategies. To highlight the negative correlation between value and momentum, he creates a portfolio for each region with equal weights in value and momentum.

Studying the degree of correlation between value and momentum in each region, he uses the correlation value to create optimal (Sharpe ratio–maximizing) portfolios for each region by assigning different weights to the value strategy and the momentum strategy. Finally, the author performs a factor regression analysis using the Fama–French three-factor model (using market exposure, size, and value as the three factors) on the momentum strategy across the four regions and the All region.

The key finding is that the results in Japan do not disprove the momentum strategy. The author shows that, instead, the results are ultimately supportive of momentum strategies. He confirms the basic finding that value and momentum work nearly everywhere but that momentum does not work in Japan. He shows that given the success of both value and momentum strategies around the globe, the chance of one strategy delivering poor results in one region is quite high. An optimized portfolio that uses both value and momentum would still do well investing heavily in the Japanese momentum strategy, despite its poor performance. Using the three-factor model, the author finds the size of the momentum strategy’s intercept in Japan to be economically and statistically large, meaning that net of market exposure, size, and value, momentum strategies have added considerable return over the period of study.

The supposed failure of Japanese momentum is not at all statistically significant, and there is a considerable chance that it is just random noise. The author concludes that the portfolio of a Japanese investor with access to the value strategy would have performed much better if it had included momentum. By viewing value and momentum as a system that has negative correlation and using a three-factor model for support, the author provides indications that momentum in Japan is a strong empirical success.

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