September 22, 2009
Why does it work?
Asness offered several explanations for why momentum has persisted in the market.
From a behavioral standpoint, investors are slow to adjust to news because of “anchoring” and a reluctance to abandon long-held beliefs. Thus, when news comes out, prices only move part of the way. Buying recent winners is a good idea because they still have some distance to go. Investors may also overreact to good news; once prices incorporate the effect of good news, they go up further than they should, so again buying recent winners, and selling recent losers, would work.
And there is also something called the “disposition effect” – investors are more likely to sell their winners too early and hold their losers too long, waiting for them to come back. If investors sell their winners too quickly, they won’t be able to get a fair price – implying that stocks on their way up will continue to go up.
There are also efficient-market explanations (Asness’ PhD advisor was Gene Fama, one of the foremost advocates of efficient markets), but they are weaker. The fact that momentum works consistently in many environments may support the efficient market claim that it is a risk factor. But momentum actually does much better during liquidity crises, while value underperforms – an argument against an efficient market explanation for momentum. Efficient market theory dictates that momentum doing well in a liquidity crisis is a good feature, and investors should accept lower returns on momentum, not the opposite (higher), which has been consistently the case.
Asness stressed that these are just theories and none offer conclusive explanations for the momentum effect.
In fairness, momentum is not alone. Practitioners also still debate the source of the value premium – whether it is a risk premium or a behavioral phenomenon, and Asness rightly claims that momentum should not be held to a higher standard.
Turnover and taxes
Two large and interrelated concerns about momentum are high turnover and tax inefficiency.
Asness admitted that momentum has higher turnover (approximately 150%) than either value or growth, but the trading costs are “not that bad,” he said. He and his team have spent a lot of time working on this issue and, through electronic trading, have minimized many of those costs. “Trading costs have taken out only a very modest portion of total return,” he said.
Taxes, he said, are mostly an issue for the future, since “investors today have plenty of losses against which to net gains from momentum.” His funds are also designed to be more tax-efficient than just following momentum blindly. For example, they trade tax lots so as to minimize taxes for shareholders.
In spite of turnover and taxes, Asness said, “outperformance is large and survives these issues.”
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