Momentum investing: A survey

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Laurens Swinkels obtained his Master’s and PhD degree in Econometrics at the CentER Graduate School of Tilburg University. He joined the Quantitative Research department of the Robeco Group in April 2004. Prior to this he was a part-time researcher at ABP Investments for four years and a quantitative analyst at PensionFactory for one year. Office 16–26, Quantitative Research, Robeco Group, PO Box 973, NL 3000 AZ, Rotterdam, The Netherlands E-mail: [email protected]

Abstract Research on the profitability of stock return momentum strategies has been very active in the past decade. This paper gives an overview of this strand of literature. It discusses the empirical results and research methods that have been used to obtain them. The momentum return is decomposed in order to find the driving force behind the momentum effect. In addition, a variety of explanations for the momentum effect, such as a compensation for risk or investor trading behaviour, are summarised. Some recent papers investigating the profitability of momentum strategies for institutional investors when explicitly taking transactions cost estimates into account are also touched upon. Keywords: momentum effect, portfolio management, stock return decomposition, transaction costs

Introduction Simple trading strategies have attracted attention since the early days of stock trading. Probably the most obvious strategies are trading strategies based on the past return pattern of stocks. This paper summarises the existing literature on patterns of return continuation. It focuses on cross-sectional patterns, ie the relation between the relative return of a stock versus the market based on its relative return in the previous period, instead of the time-series predictability known as technical analysis. These cross-sectional patterns are called momentum or contrarian strategies, depending on return continuation or reversals in the subsequent investment horizon. A momentum (contrarian) strategy is based on a simple rule; buy stocks that performed best (worst) and

120

Journal of Asset Management

sell stocks that performed worst (best) in the recent past. This paper focuses on strategies that examine medium term return continuation. The next section discusses the empirical findings in the momentum literature. The seminal paper on the momentum effect is by Jegadeesh and Titman (1993), who suggest that high returns continue to be high, and low returns continue to be low on a horizon of 3–12 months. They find an excess return of about 12 per cent per year for US stocks on a zero-investment portfolio long in stocks with high six-month returns, and short in stocks with low six-month returns. Several authors have gathered out-of-sample evidence on the momentum effect for other stock markets. Moreover, Jegadeesh and Titman (2001) claim that momentum is present in an out-of-sample period, the

Vol. 5, 2, 120–143

Henry Stewart Publications 1479-179X (2004)

Momentum investing

decade after their initial observation. These findings cast doubt on the explanation tha