“There are patterns in average stock returns that are considered anomalies because they are not explained by the Capital Asset Pricing Model…The premier anomaly is momentum.” Fama - French "Dissecting Anomalies " Journal of Finance
Many now agree that momentum is not an anomaly but a core risk premium strategy whereby investors receive excess return for following trends either through time series or cross sectional models. It is not an aberration that will go away through better modeling or through identification.
There are a number of reasons for why momentum will work, from behavioral arguments about slow adjustment, under-reaction and then over-reaction, to being paid as an offset to the risk of crashes from herding. A slow speed of adjustment based on behavioral biases seems to fit data and in spite of our knowledge will not easily go away. Additionally, in an uncertain world, cautious behavior is the norm as investors seek confirming evidence. Many arguments are suggestive, but the rationale for trends is still a work in progress with competing narratives. Momentum occurs because there are frictions in markets that run from behavioral, informational, and structural. Nevertheless, it does not change the fact that trends and momentum are the most consistent risk factors measured through time. Frictions do not stop markets from reaching their destination but slows the process which leads to opportunities for those that follow price dynamics.
There are a number of reasons for why momentum will work, from behavioral arguments about slow adjustment, under-reaction and then over-reaction, to being paid as an offset to the risk of crashes from herding. A slow speed of adjustment based on behavioral biases seems to fit data and in spite of our knowledge will not easily go away. Additionally, in an uncertain world, cautious behavior is the norm as investors seek confirming evidence. Many arguments are suggestive, but the rationale for trends is still a work in progress with competing narratives. Momentum occurs because there are frictions in markets that run from behavioral, informational, and structural. Nevertheless, it does not change the fact that trends and momentum are the most consistent risk factors measured through time. Frictions do not stop markets from reaching their destination but slows the process which leads to opportunities for those that follow price dynamics.
The momentum factor, both cross-sectional and time series, has shown long-run return consistency. Yet, long-run consistency does not mean that money will be made every year or that there will not be periods of significant under performance relative to other risk premiums. Poor momentum performance today will lead to futures positive performance tomorrow as this style loses popularity. A time varying risk factor cannot be confused with an anomaly
This does not mean that momentum trades cannot be crowded, but the underlying nature of trend and momentum makes crowding difficult. Too many investors engaging in a trend trade will not cause trends to disappear. Rather, too many investors will cause the trend to move faster to some equilibrium with the potential to overshoot and then reverse. Slow traders who follow long-term trends will under-perform but faster traders with shorter investment horizons may outperform. Time-frame switches lead to under-performance for the single time frame static trader. This time-frame dynamic is one of the key challenges for any follower of momentum. Crowds change trends and require time-frame diversification. Research shows that momentum will not always be the same.
Similarly, the behavior of one market will not be the same as others. Structure, costs, liquidity, and the mix of market participants will change the characteristics of momentum but not eliminate the factor. A given market will have its own time varying momentum returns. These aggregated returns across all asset classes show positive returns. Momentum is not a anomaly but part of a market process where returns associated with price dynamics ebbs and flows.
This does not mean that momentum trades cannot be crowded, but the underlying nature of trend and momentum makes crowding difficult. Too many investors engaging in a trend trade will not cause trends to disappear. Rather, too many investors will cause the trend to move faster to some equilibrium with the potential to overshoot and then reverse. Slow traders who follow long-term trends will under-perform but faster traders with shorter investment horizons may outperform. Time-frame switches lead to under-performance for the single time frame static trader. This time-frame dynamic is one of the key challenges for any follower of momentum. Crowds change trends and require time-frame diversification. Research shows that momentum will not always be the same.
Similarly, the behavior of one market will not be the same as others. Structure, costs, liquidity, and the mix of market participants will change the characteristics of momentum but not eliminate the factor. A given market will have its own time varying momentum returns. These aggregated returns across all asset classes show positive returns. Momentum is not a anomaly but part of a market process where returns associated with price dynamics ebbs and flows.
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