A trading strategy of buying winners and selling losers worked well for several decades. Since 1999, the abnormal positive returns that had accrued to such a “momentum” strategy have disappeared. Rather than being driven by a shift in the market dynamic, the change was driven by—among other factors—investors themselves uncovering the abnormality.
How Is This Research Useful to Practitioners?
The authors test the efficacy of momentum (buying winners and shorting losers) as a strategy over 1965–2012. They find strong evidence that the momentum strategy produced excess (abnormal) returns over 1965–1989. Although the authors observe momentum profits over 1990–1998, the evidence is less strong. Their results show a decline in momentum profits to insignificant levels over 1999–2012.
Importantly, these results are robust across a host of subsamples. For example, the authors test whether the instances of extreme stock market volatility during 1999–2012 were responsible for the death of the momentum strategy and find that they were not. They also examine the 1965–1998 period for 14-year stretches (which match the duration of the 1999–2012 period) when the momentum strategy was not profitable and find none.
Three possible explanations for the disappearance of momentum profits are put forward. The authors’ first hypothesis is the uncovering of the anomaly itself, with the mispricing corrected during the identification period on the back of an intensified reaction to winners and losers. They find evidence consistent with this prediction. The authors’ second hypothesis is a decline in the risk premium on a macroeconomic factor; they find that momentum profits no longer reflect compensation for a risk factor—for example, industrial production. Finally, the authors speculate that improved market efficiency—with information priced in more quickly—is responsible for the disappearance of the momentum anomaly and find evidence to support this view.
All market participants with an active approach—including both traders and investors as well as those evaluating money manager performance—should be interested in these findings.
How Did the Authors Conduct This Research?
The sample is constructed from all stocks trading on the NYSE, AMEX, and NASDAQ, excluding stocks trading below $5 and the NYSE lowest-size decile. The analysis spans 1965–2012, divided into three subperiods: 1965–1989, 1990–1998, and 1999–2012. The authors examine the profitability of 16 strategies that pick stocks on the basis of their returns over the past 3, 6, 9, or 12 months, which are then held for 3, 6, 9, or 12 months. They conduct Fama–French (Journal of Finance 1992) regressions of individual stocks’ monthly returns on their past cumulative returns, controlling for post-ranking beta, size, and book-to-market equity.
To test their hypothesis that an increase in awareness of the momentum strategy is behind its demise, the authors compute the buy-and-hold abnormal returns of new winner and loser stocks during the identification period and the following 24 months. To test the potential reduced risk premium associated with a macroeconomic variable, they compute the loadings of loser, winner, and winner–loser portfolio returns on industrial production growth. The authors use monthly regressions of these portfolio returns to estimate the loadings on the three Fama–French factors (size, price-to-book value, and beta) and the growth rate of industrial production.
They observe a significant reduction in “delay” in the data, which signals an increase in market efficiency. This delay is computed by subtracting from 1 the ratio of the adjusted R2 of the “restricted” market model to the adjusted R2 of the “unrestricted” market model.
Abstractor’s Viewpoint
The rise in popularity of passive fund management is a key feature of today’s investment landscape. Linked to this trend is the failure of active managers to deliver adequate risk-adjusted returns. The disappearance of such market anomalies as momentum has doubtless been a key driver of the deterioration in active manager performance.
The authors put forward a theory that the uncovering of the momentum strategy was a factor in its disappearance. This theory suggests that investment professionals should exercise caution when counting on other trading strategies that have generated positive excess returns in the past to continue to do so in the future.
It is possible that momentum as a strategy is not permanently dead. For example, the “Blue Monday” effect, made popular by Yale Hirsch’s 1987 book Don’t Sell Stocks on Monday, disappeared soon after the book was published, only to make something of a comeback in the past 10–15 years. As momentum funds fold and traders give up on momentum as a strategy, it will be interesting to see whether the anomaly re-emerges.
It would also be interesting to see whether a similar pattern could be observed in foreign equity markets. A study of emerging and frontier equity markets, many of which are less efficient than the US stock market, would be particularly interesting. Finally, the authors look at momentum as a strategy; it is important not to confuse momentum with trend following.