Blog - Investing Notes

July 19, 2005 – Why Momentum Investing Works?

In their July 2005 paper entitled "Momentum Profits and Non-Normality Risks", Ana-Maria Fuertes, Joelle Miffre and Wooi Hou Tan examine the distributions of returns for nine momentum investing strategies as they attempt to explain why the resultant portfolios outperform. Using monthly data spanning 2/73-8/04 for NYSE, AMEX and NASDAQ stocks and equally weighted portfolios, they find that:

• All nine momentum strategies they examine show significant performance advantages for past winners over past losers (see chart below).
• The standard deviations of the past winner portfolios is consistently just smaller than those for past losers, so reward-for-volatility risk does not explain the outperformance of past winners.
• The distributions of winner returns consistently deviate more from normal than do loser returns, exhibiting a more negative skewness (the distribution curve tilts to the right) and kurtosis (flattened, with fat tails). Rewards for these distribution abnormalities may partially explain why momentum strategies work.
• Momentum portfolios tend to follow the rhythms of the business cycle, incorporating more risk (higher beta and more negative skewness) during economic expansions than during recessions.
• Efficient market theory still cannot explain fully the outperformance of momentum investing. Illiquidity and transaction costs may be part of the puzzle. The alternative view of behavioral economists, that momentum is a consequence of the market responding slowly to news, is still in play.

The following chart illustrates the annualized returns for all nine momentum strategies. The strategies devolve from two parameters: (1) the intervals of past performance used to rank stocks for momentum (R3 = last three months, R6 = last six months, R12 = last 12 months); and, (2) the holding periods for the portfolios tested (H3 = three months; H6 = six months, H12 = 12 months). All such portfolios generate considerably higher average returns for past winners than for past losers. Ranking based on a past performance period of 12 months and a holding period of three months produces the largest difference.

In summary, momentum investing works, and abnormalities in the distribution of returns for momentum-driven portfolios may partly explain why. A complete explanation of the success of momentum investing, however, remains elusive.

For related research, see Blog Synthesis: Momentum Investing/Trading.