Momentum investing is a technique for investing in stocks or other securities with high returns in the last three to twelve months and selling those with low returns in the same time frame.
While momentum investing is a well-known phenomenon, economists are having problems reconciling it with the efficient market hypothesis and the random walk hypothesis. In terms of an efficient market, two primary hypotheses have been proposed to explain the momentum effect. In the first, it is considered that momentum investors take on a large amount of risk by following this approach and that the high returns compensate for the risk. Momentum methods frequently entail disproportionately investing in equities with wide bid-ask spreads, and as a result, they can be risky.
The momentum factor is one of the most well-known market anomalies in capital market theory. Securities that have climbed in recent months have been seen in studies to continue to rise for a few more months. A varying magnitude of influence was discovered depending on whatever prior time was used as a reference and how long the securities were held after then. In the case of securities that have recently lost value, the same rule applies. One explanation is the so-called post-earnings-publication drift, which argues that following the announcement of better-than-expected earnings statistics, investors do not fully price in the higher enterprise value. The share price grows slowly and steadily until it reaches its genuine greater worth after a period of time.
Momentum techniques take advantage of the tendency for a stock’s historical returns and earnings news to forecast future returns. The authors affirm the trend for the next six months and a year. After controlling for the other, prior returns and earnings contribute to expected future returns. The authors discover that the outcomes are unrelated to the size of the company or the book-to-market ratios. The market’s delayed response to fresh information is also evidenced by the slow response of analysts’ earnings projections to recent news.
Past stock returns can help forecast future returns, according to finance literature. Stock price reversals are explained in this literature, but stock price momentum is not. Underreaction to earnings-related information, market overreaction as a result of feedback methods, and earnings momentum are all potential sources of price momentum.
We can analyze the real-world profitability of momentum strategies by looking at the performance of genuine mutual funds. We looked for funds in Morningstar’s US equity category that had the word “momentum” in their name and had returned for at least 36 months. We didn’t include multifactor funds since we wanted to make sure the funds we chose had a strong focus on momentum. Exhibit 2 shows summary statistics for the final sample of 11 funds.
As the momentum coefficient column shows, these strategies have had a lot of momentum premium exposure. The average turnover was high, which is in line with scholarly research on momentum premiums. The average momentum premium for each fund throughout the time period studied is reported in the second-to-last column. As assessed by the average, most of these methods have seen a significant momentum premium.
Source: stock scanners