Profitability of Momentum Strategies: An Evaluation of Alternative Explanations (Part 2)

An academic paper read by Sawyer Investment Management Company regarding the source of momentum returns. (Part 2)

Abstract:
This paper evaluates various explanations for the profitability of momentum strategies documented in Jegadeesh and Titman (1993). The evidence indicates that momentum profits have continued in the 1990s, suggesting that the original results were not a product of data snooping bias. The paper also examines the predictions of recent behavioral models that propose that momentum profits are due to delayed overreactions that are eventually reversed. Our evidence provides support for the behavioral models, but this support should be tempered with caution.

Citation:
Jegadeesh, N., & Titman, S. (2001). Profitability of Momentum Strategies: An Evaluation of Alternative Explanations. Journal of Finance, 56(2), 699–720.

Link to Paper:
http://www.trendrating.com/wp-content/uploads/white-papers/profitability_of_momentum_strategies.pdf

About Sawyer Investment Management Company:
SIMCO is a Texas-registered Investment Adviser with its principal place of business in Dallas, Texas. It was formed on January 1, 2015 and is wholly owned by Ryan Sawyer, who is a CFA Charterholder and a Certified Public Accountant.

SIMCO specializes in the construction of equity portfolios, and is therefore an ideal resource for long-term investors. The firm goes through a rigorous process for selecting each and every holding in the portfolio. Rooted in the empirical research of academia, the portfolios are generally characterized as large-cap value momentum. For more information about how the portfolios are managed, see our website.

www.sawyerinvestment.com
https://www.facebook.com/Sawyer-Investment-Management-Company-1588110057913467/
https://twitter.com/SawyerInvest
https://sawyerinvestment.blogspot.com/

Profitability of Momentum Strategies: An Evaluation of Alternative Explanations

An academic paper read by Sawyer Investment Management Company regarding the source of momentum returns.

Abstract:
This paper evaluates various explanations for the profitability of momentum strategies documented in Jegadeesh and Titman (1993). The evidence indicates that momentum profits have continued in the 1990s, suggesting that the original results were not a product of data snooping bias. The paper also examines the predictions of recent behavioral models that propose that momentum profits are due to delayed overreactions that are eventually reversed. Our evidence provides support for the behavioral models, but this support should be tempered with caution.

Citation:
Jegadeesh, N., & Titman, S. (2001). Profitability of Momentum Strategies: An Evaluation of Alternative Explanations. Journal of Finance, 56(2), 699–720.

Link to Paper: http://www.trendrating.com/wp-content...

About Sawyer Investment Management Company:
SIMCO is a Texas-registered Investment Adviser with its principal place of business in Dallas, Texas. It was formed on January 1, 2015 and is wholly owned by Ryan Sawyer, who is a CFA Charterholder and a Certified Public Accountant. SIMCO specializes in the construction of equity portfolios, and is therefore an ideal resource for long-term investors. The firm goes through a rigorous process for selecting each and every holding in the portfolio. Rooted in the empirical research of academia, the portfolios are generally characterized as large-cap value momentum. For more information about how the portfolios are managed, see our website.

www.sawyerinvestment.com 
https://www.facebook.com/Sawyer-Inves...
https://twitter.com/SawyerInvest

Returns to Buying Winners and Selling Losers: Implications for Stock Market Efficiency (Part 2)

An academic paper summarized by Sawyer Investment Management Company regarding the abnormal returns attributable to owning momentum stocks.

Abstract: This paper documents that strategies which buy stocks that have performed well in the past and sell stocks that have performed poorly in the past generate significant positive returns over 3- to 12-month holding periods. We find that the profitability of these strategies are not due to their systematic risk or to delayed stock price reactions to common factors. However, part of the abnormal returns generated in the first year after portfolio formation dissipates in the following two years. A similar pattern of returns around the earnings announcements of past winners and losers is also documented.

Citation: Jegadeesh, N., & Titman, S. (1993). Returns to Buying Winners and Selling Losers: Implications for Stock Market Efficiency. Journal of Finance, 48(1), 65–91.

Link to Paper: http://www.business.unr.edu/faculty/liuc/files/BADM742/Jegadeesh_Titman_1993.pdf

About Sawyer Investment Management Company: SIMCO is a Texas-registered Investment Adviser with its principal place of business in Dallas, Texas. It was formed on January 1, 2015 and is wholly owned by Ryan Sawyer, who is a CFA Charterholder and a Certified Public Accountant.

SIMCO specializes in the construction of equity portfolios, and is therefore an ideal resource for long-term investors. The firm goes through a rigorous process for selecting each and every holding in the portfolio. Rooted in the empirical research of academia, the portfolios are generally characterized as large-cap value momentum. For more information about how the portfolios are managed, see our website.

www.sawyerinvestement.com 
https://www.facebook.com/Sawyer-Investment-Management-Company-1588110057913467/
https://twitter.com/SawyerInvest
https://sawyerinvestment.blogspot.com/

Returns to Buying Winners and Selling Losers: Implications for Stock Market Efficiency (Part 1)

Buying past winners and selling past losers tends to earn abnormal profits over holding periods less than a year.

 

Jegadeesh, N., & Titman, S. (1993). Returns to Buying Winners and Selling Losers: Implications for Stock Market Efficiency. Journal of Finance, 48(1), 65–91.

Market Efficiency in an Irrational World

Traditionally, economic theory takes the view that investors are rational; but several behavioral biases such as Overconfidence have been studied recently.  In particular, this overconfidence has been found to indirectly cause investors to underweight or overweight new information (caused by the "cognitive dissonance", "attribution bias", and "conservatism bias"), contributing to the momentum effect.  The authors propose that growth stocks (i.e., low book-to-market ratios) should exhibit higher momentum due to their value being less predictable (e.g., most of their assets are intangible) than more stable stocks.

The authors study the July 1963 - December 1997 period in the United States equity markets and find that stocks with high Book-to-Market characteristics (i.e., value stocks) and high TTM returns (i.e., momentum stocks) significantly outperformed their growth and low momentum counterparts, as well as the market portfolio.  The value/momentum portfolio outperformed the market portfolio by almost 0.60% per month.

The authors introduce "adaptive efficiency", which relaxes the efficient market hypothesis by adding behavioral theory.  They suggest that the "irrational investors" may tilt their portfolios to anomalies, while the "rational investors" assume that anomalies are corrected by rational investors and will not try to exploit the anomalies; and this will cause the anomalies (such as momentum) to persist.  The authors prove this to be the case over the 1974 - 1997 period in the United States equity markets.

DANIEL, K., & TITMAN, S. (1999). Market Efficiency in an Irrational World. Financial Analysts Journal, 55.

Cross-sectional and Time-series Determinants of Momentum Returns

Previous studies have found that previous winners over a 3-12 month period will show 1%/month profits over the next 12 months.  This has been empirically confirmed across several markets and time periods, even back to the 1920s.

Several reasons for this phenomenon to occur have been proposed: under-reaction to information; delayed over-reaction to information; or an undetected risk.  In particular Conrad and Karl in a previous study find it to be due to cross-sectional dispersion in unconditional expected returns.

The authors find Conrad and Karl's study to be flawed due to a small sample bias, and they prove that their conclusion explains very little, if any, of the momentum profits.  In fact, they say "virtually none of the momentum profits can be attributed to compensation for risk."

Jegadeesh, N., & Titman, S. (2002). Cross-Sectional and Time-Series Determinants of Momentum Returns. Review of Financial Studies, 15(1), 143–157.