What causes momentum, or what is associated with momentum? A new paper suggests that there is a strong link between liquidity and momentum, and that changes in liquidity precede momentum gains.
The paper, titled “Momentum Returns and the Role of Liquidity Improvements” by Jeppe Bro, demonstrates that the traditional stock market momentum anomaly is actually driven by cross-sectional liquidity dynamics rather than representing an independent risk premium.
The novel idea is that past winners systematically see their trading liquidity improve before a portfolio is formed, while losers see liquidity deterioration. The momentum price drift is the market adjusting to these new liquidity states. The author calls this the Liquidity Improvement Factor, and when including this factor, there is no momentum alpha. The data shows mixed results pre-2000 data relative to more recent data. Any momentum effect is drift toward high-liquidity stocks and is a byproduct of liquidity dynamics. This is the most recent paper that attempts to explain the momentum factor.
This is a very interesting thesis. Investors should track or follow liquidity changes to enhance any measure of momentum. I have some issues with the Amihud measure of liquidity, which looks at absolute return divided by vol and is manipulated to form liquidity differences. Still, I do not have a better alternative at this time.
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