For a few months now we have been exploring some of the theories and strategies behind momentum investing. For a concept that only started to receive rigorous academic testing in the 1990s, momentum has emerged as a major source of superior returns, with reams of research to back it up, providing intellectual support for those hardened TA investors who've always maintained that there's something in those price charts after all. But while the buy-high-sell-higher phenomenon is now widely acknowledged, the reason why momentum even exists – and why you can take advantage of it – remains less well understood.
When US academics Jegadeesh and Titman revealed to the investing world their backtested theories about momentum in 1993, they acknowledged that the reasons why the phenomenon existed were unclear. Their findings showed that that stocks that perform the best over a three- to 12-month period tend to continue to perform well over the subsequent three to 12 months. To explain this, they only got as far as suggesting that investor expectations are systematically biased and that under-reaction to news about a stock was likely to be playing a role. Since then, investing professionals and academics have gone to town on trying to figure out what really causes momentum.
It could be down to risk…
Broadly speaking there are two camps on what the cause of the momentum effect really is; the first of which argues that investors balance the risk of a momentum strategy by demanding higher returns. The second puts much more emphasis on the behavioural instincts of investors for influencing the phenomenon.
In terms of risk-based explanations, research is comparatively thin on the ground. It could be the case that momentum returns are just compensation to investors for some unique risk associated with momentum investing but, if so, it's hard to fathom what this risk is. While momentum strategies are known to infrequently ‘crash’ when markets suddenly turn, momentum stocks typically display high Sharpe ratios, which means that they produce higher risk-adjusted returns compared to, say, growth stocks. In Kent Daniel’s 2011 research Momentum Crashes, he concluded that: “By virtue of the high Sharpe-ratios associated with the momentum effect, they are difficult to explain within the standard rational-expectations asset pricing framework.” A subsequent paper by Rachwalski and Wen in 2012 entitled Momentum, Risk, and Underreaction concluded that “a purely risk-based…