Quantitative Momentum

Preface

The efficient market hypothesis suggests that past prices cannot predict future success. But there is a problem: past prices do predict future expected performance and this problem is generically labeled “momentum.” Momentum is the epitome of a simple strategy even your grandmother would understand—buy winners. And momentum is an open secret. The track record associated with buying past winners now extends over 200 years and has become the ultimate black eye for the efficient market hypothesis (EMH). So why isn't everyone a momentum investor? We believe there are two reasons: hard-wired behavioral biases cause many investors to be anti-momentum traders, and for the professional, who wants to exploit momentum, marketplace constraints make this a challenging enterprise.

As long as human beings suffer from systematic expectation errors, prices have the potential to deviate from fundamentals. In the context of value investing, this expectation error seems to be an overreaction to negative news, on average; for momentum, the expectation error is surprisingly tied to an underreaction to positive news (some argue it is an overreaction, which cannot be ruled out, but the collective evidence is more supportive of the undereaction hypothesis). So investors that believe that behavioral bias drives the long-term excess returns associated with value investing already believe in the key mechanism that drives the long-term sustainability of momentum. In short, value and momentum represent ...