Momentum Investing: It Works, But Why?


Featured Research by: Avanidhar Subrahmanyam, Distinguished Professor of Finance, Goldyne and Irwin Hearsh Chair in Money and Banking

Momentum Investing: It Works, But Why?

After a quarter century of sprawling study, it’s time to narrow the focus and settle on an explanation

Conventional wisdom says that once any stock-picking strategy nears “sure thing” status it should be doomed. If everyone knows the secret to vast riches, how could the strategy possibly work anymore?

But there is a successful strategy that has been followed — and widely discussed — for decades, yet somehow persists as a relatively reliable money-maker: “momentum” investing, which is betting that the stock market’s recent winners will remain winners in the near term and, likewise, that the recent losers will remain losers. The strategy also is known as “relative strength” investing.

In the academic world, the pioneering research on momentum was a 1993 study published in the Journal of Finance by Narasimhan Jegadeesh and Sheridan Titman, both at UCLA Anderson at the time. They documented how strategies of buying recent stock winners and selling recent losers generated significantly higher near-term returns than the U.S. market overall from 1965 to 1989.

The authors established the basic time frame for momentum-investing success as a three-to-12-month window on either side. In other words, a stock’s relative performance over the previous three to 12 months typically predicted its relative performance for the following three to 12 months. They measured various time combinations of prior returns and future returns within those windows and found trading them to be “on average quite profitable” strategies. For example, a portfolio that selected stocks based on their previous six-month returns, and then held them for six months, generated an extra return of about 1 percent per month above what would have been expected. Added up over time, that return premium, compared with the market return, can turn into a rich payoff.

But Jegadeesh and Titman didn’t attempt to explain precisely why momentum investing should work so well. And in the ensuing 25 years, the question has defied a definitive answer, says UCLA Anderson’s Avanidhar Subrahmanyam. “We are still no closer to finding a discernible cause for this phenomenon, in spite of the extensive work on the topic,” he says. “Including these assets classes can improve expected retirement income and mitigate loss in downside scenarios,” according to the report, titled, “The Evolution of Target Date Funds: Using Alternatives to Improve Retirement Plan Outcomes.”

Subrahmanyam thinks it’s high time to solve the mystery. In a review article published in August 2018 in the Pacific-Basin Finance Journal, he made the case that a deeper understanding of momentum has been hampered because “so many explanations [have been suggested] without any attempt to test for mutual exclusivity of the predictions.” Subrahmanyam surveys the existing work on the topic, seeks to categorize it and then suggests how to narrow future inquiry to find consensus on the explanation behind momentum investing. It isn’t a traditional research paper, but a possible roadmap for its author and others.

“I argue that effort should be focused on ruling out alternative explanations for momentum and trying to home in on the ‘true’ explanation(s) rather than allowing the finding [of momentum] to get ‘over-identified’ via multiple stories for the same phenomenon,” he writes.
There’s a good reason for academics to want to nail down the key factor behind momentum’s success: As an investment strategy, it’s a thumb in the eye of the “efficient market hypothesis” (EMH), one of the central tenets of modern finance. EMH, developed by the economist Eugene Fama in the 1960s, holds that a stock’s price at any moment reflects all of the relevant information about the company. So it’s impossible to ferret out a bargain because investors are rational beings and share prices are always exactly what they “should” be, given what investors collectively know.

That, of course, is the argument that has made index (or “passive”) stock investing so incredibly popular over the last 20 years: You can’t outsmart the market, so just own the whole thing.

Yet various styles of momentum investing continue to reward their investor practitioners with above-average returns. It doesn’t work in every market environment. And momentum stocks are subject to sharp reversals that can leave trend-followers badly bloodied. Nonetheless, a 2014 study by a team led by hedge fund billionaire Clifford Asness urged momentum-doubters to surrender, already. “The existence of momentum,” they wrote, has become “a well-established empirical fact.”
In an interview, Subrahmanyam said he considers momentum investing to be not just one of the bigger challenges to the efficient market hypothesis, but rather, “I would say it is the biggest. It is, first, trivially simple to exploit and, second, is robust through time” in its market-beating performance. In fact, a 2013 study looked back 215 years and confirmed that the ability to earn premiums from momentum strategies existed not just in U.S. stocks but in foreign markets, bonds, currencies and commodities.

Still, the question persists: Why does momentum work? In his research into 25 years of academic literature on momentum, Subrahmanyam found that many of the rationales presented for the strategy’s success fall into one of two behavioral categories: Investors either overreact to important information, or they underreact to it. Because, after all, we’re only human.
Apart from the behavioral overreaction/underreaction theories, Subrahmanyam notes that some researchers believe that the premiums earned from momentum strategies are merely the logical market payoff for taking greater risk. In other words, if you assume that momentum stocks’ riskiness rises as the stocks climb, there should be a higher reward for accepting higher risk.

Subrahmanyam doesn’t favor one theory over another in the hunt for what drives momentum returns. But he suggests fellow researchers’ time would be better spent narrowing down the field of possible explanations before adding new ones.
“The literature is fragmented and everyone has their own story,” he says. “But our job as professors is to try and nail down the truth. I am trying to push the profession to focus the research better.”