Thursday, November 8, 2018

25 years after Jegadeesh and Titman - The Momentum Revolution

Trend-following and momentum has always been an important part of hedge funds and alternative investing but it would be hard to say that trend-following was mainstream thinking prior to the early 90's. This was the high water period of the of market efficiency, but that thinking started to take a major change with the "Returns to Buying Winners and Selling Losers: Implications for Stock Market Efficiency", published in the leading Journal of Finance. There were other papers that discussed similar topics and the behavioral finance paradigm shift had already begun, but this was the one paper that many academics started to quote with increasing frequency about momentum effects. 

The paper was elegance was its simplicity. It showed that if you followed a strategy of buying past positive performers against a portfolio of losers, there would be significant excess returns. The tests were done using past returns not trend but the results transfer. It was not a paper about technical signals or moving averages. It just looked at past returns with significant look back.

We are now 25 years away from this path breaking work albeit it is unlikely that most academics or traders will hoist a beer to the authors in celebration. For core followers of trend, this is no big deal. The celebration of trend-following is much older, but for the mainstream this is as good as any place to mark a change in investment paradigm.

25 years later, momentum and trend-following are a core part of investment thinking. These are not just considered investment strategies but fundamental risk premia. The discussion has moved from thinking about ways to dismiss these risk premia to offering reasons for their existence. What trend-followers knew but may mot have clearly articulated is that behavior creates slower reaction to news. Biases drive trends. 

Nevertheless, some of the terms and language has changed to suit academics over older practitioners. Academics like to use the word momentum and askew trend. There is now a clear distinction between cross-sectional and times series momentum. The classic trend-follower will think the cross sectional approach is a form of ordering trend preference. No one uses the words technical analysis. Preference is for quantitative analysis and algos.

25 years into momentum and trend style acceptance, researchers have looked at an ever-increasing set of data over markets and time to show that trends exist. Of course, there is an ebb and flow with returns associated with these strategies but over the long run, you can go to the bank that the risk premia is present.

Can there be too many following this risk premia? That is, can popularity kill the golden goose of momentum? From a theoretical level, as long as there are trends in fundamentals, behavioral biases, limits to arbitrage, and uncertainty, there will be frictions that allow for trends. From a practical side, trend behavior and returns will change with the time length of trends, speed of reaction, differences in crowding, congestion, and liquidity. Momentum/trend returns will grow and decline which will force some to leave the strategy and others to jump in. There is a dynamic environment which will ensure that everyone cannot be a winner at all times, but for the patient, momentum/trend should work over the next 25 years.

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