Persistency of the momentum effect

Date01 November 2018
Published date01 November 2018
DOI: 10.1111/eufm.12140
Persistency of the momentum effect
Hong-Yi Chen
Pin-Huang Chou
Chia-Hsun Hsieh
Department of Finance, National
Chengchi University, Taiwan, 64, Zhinan
Rd., Taipei 11605, Taiwan
Department of Finance, National Central
University, Taiwan, 300, Zhongda Rd.,
Taoyuan City 32001, Taiwan
The intermediate-term momentum persistency is not
universal among all stocks. More than 40% of winners
and losers immediately fall out of their respective groups in
the month following formation, resulting in a monthly loss
of more than 17% for a momentum strategy constructed on
such stocks. By contrast, persistent winners and losers,
defined as those staying in their groups for at least one more
month, exhibit much stronger momentum persistency.
Further analysis indicates that, consistent with the delayed
reaction hypothesis for price momentum, the persistency is
stronger for stocks with greater information asymmetry and
more extensively heterogeneous investor beliefs.
delayed reaction hypothesis, duration, heterogeneous beliefs,
information asymmetry, persistent momentum strategy
G11, G14
The existence of intermediate-term price momentum, as documented by Jegadeesh and Titman (1993),
remains one of the most robust puzzles in financial research. A variety of theories offer explanations of
The authors are especially grateful to John Doukas (the Editor) and the anonymous ref eree for valuable suggestions.
The authors also appreciate helpful comments from Stephen Brown, Chun-Yang Hwang, Cheng-Few Lee, Ghon
Rhee, as well as seminar participants at National Taiwan University, National Chengchi University, 2014 Financial
Management Association Annual Meeting (Nashville, USA), the 22nd Annual Conference on Pacific Basin Finance,
Economics, Accounting, and Management (Nagoya, Japan), and the 7th Annual Financial Engineering and Risk
Management Conference (Hsinchu, Taiwan). Previous versions of this paper were circulated under the title
Profitability of Momentum Strategies: The Role of Consistent Winners and Losers.
© 2017 John Wiley & Sons, Ltd. Eur Financ Manag. 2018;24:856892.
the momentum effect, ranging from rational accounts, such as risk-based explanations (e.g., Asness,
Moskowitz, & Pedersen, 2013; Barroso & Santa-Clara, 2015; Liu & Zhang, 2008; Sadka, 2006) and
limits to arbitrage (Arena, Haggard, & Yan, 2008), to behavioral explanations, such as overreaction
(e.g., Byun, Lim, & Yun, 2016; Chui, Titman, & Wei, 2010; Cooper, Gutierrez, & Hameed, 2004;
Daniel, Hirshleifer, & Subrahmanyam, 1998; Hillert, Jacobs, & Mueller, 2014) and underreaction
(e.g., Antoniou, Doukas, & Subrahmanyam, 2013; Chen & Zhao, 2012; Da, Gurun, & Warachka, 2014;
Zhang, 2006). Although researchers have extensively investigated the sources of the momentum
profits, what drives intermediate-term momentum persistency remains a problem to be solved.
In addition to the abnormal profits of momentum strategies, the persistency of the momentum
effect has been investigated in empirical asset pricing literatures. For example, Lee and Swaminathan
(2000) propose a momentum life-cycle hypothesis and demonstrate that low-volume winners and
high-volume losers do not attract investorsnotice and have a more persistent momentum effect.
Grinblatt and Moskowitz (2004) find that the return consistency can predict future stock returns.
Gutierrez and Kelley (2008) find a long-lasting momentum in weekly returns following the initial
reversal. Chen, Chen, Hsin, and Lee (2014) examine the persistency of profits for earnings, revenue,
and price momentum strategies, and find the earnings momentum strategy exhibits the strongest
persistence, while the revenue momentum strategy is relatively short lived. However, existing studies
only examine the persistency of momentum profitability at the portfolio level, ignoring the fact that
there are variations in performance at the individual firm level. Indeed, we find that, within a 6-month
formation period, approximately 47% of winner (loser) stocks fall out of their respective portfolios
immediately following formation. The return reversals that such nonpersistent winners and losers
exhibit in the month following formation are strong, resulting in a monthly loss of more than 17% for a
momentum strategy constructed on such stocks. Overall, they exhibit weak persistency in
performance. By contrast, persistent winners and losers, defined as those that stayed in their groups
for at least one more month, exhibit much stronger performance persistency. This finding suggests that
intermediate-term momentum persistency is not a universal phenomenon for all stocks with extreme
past performance. In turn, it is of interest to explore the characteristics and driving forces that give rise
to the differences in performance persistency at the individual firm level. To do so, we introduce the
winner (loser) duration as the number of months that a stock consecutively stays in the winner (loser)
portfolio and conduct a comprehensive duration analysis at the firm level to examine various risk-based
and behavioral hypotheses in explaining the persistency of the momentum effect.
We begin by providing a clearer understanding of the distribution of post-formation returns and the
turnover rates for stocks in winner and loser portfolios. We find that at least one-quarter of winner
(loser) stocks experience negative (positive) post-formation returns; thus, a momentum strategy may
fail if an investor concurrently goes long for winner stocks and shorts loser stocks. We also find that, in
terms of the 6-month formation period, more than 40% of winner and loser stocks are nonpersistent
winners and losers. Among persistent winners (losers), 18.6% (19.0%) of those stocks have only a
1-month duration, 10.8% (10.9%) have a 2-month duration, and approximately 97% persist for less than
6 months. This large dispersion of post-formation performance and high turnover rates for winner and
loser stocks inspires us to explore the difference in post-formation performance for persistent and
nonpersistent winners (losers) further. To this end, we separate winner (loser) stocks into persistent
and nonpersistent subsamples and examine their post-formation returns. The empirical results show
that during the post-formation period, persistent winners exhibit greater price appreciation than
nonpersistent winners, and persistent losers tend to lose more than nonpersistent losers.
Moreover, we demonstrate that a persistent momentum strategy, that is, buying persistent winners
and selling persistent losers, can generate monthly returns as high as 1.25%, which amounts to an
annual return of 15%. Such a persistent momentum strategy outperforms a price momentum strategy by
19 basis points in monthly returns (an 18% improvement). The persistent momentum effect remains
robust after adjusting for risk factors including the market factor, five risk factors proposed by Fama
and French (2015), Carharts (1997) momentum factor, and Pastor and Stambaughs (2003) liquidity
Among various explanations for the momentum effect, a recent and growing body of literature
demonstrates that the delayed reaction hypothesis can explain momentum profits. For example,
Barberis, Shleifer, and Vishny (1998) develop a theoretical model suggesting that conservatism bias
can lead investors to underreact to new information, and OHara (2003), Chen and Zhao (2012), and
Chen, Lee, and Shih (2016) show that greater information asymmetry will make investors react to a
firms good or bad news more conservatively, leading to a delayed price adjustment from new
information. Moreover, Dische (2002), Doukas and McKnight (2005), Hong and Stein (2007),
Banerjee, Kaniel, and Kremer (2009), Verardo (2009), Makarov and Rytchkov (2012), and
Ben-Rephael, Da, and Israelsen (2017) argue that gradual information diffusion results in greater
heterogeneity among investors (hereinafter, heterogeneous beliefs) and leads to a stronger
momentum effect. The current study therefore takes advantage of the duration of persistent winners
and losers to examine whether the information asymmetry and heterogeneous beliefs are associated
with momentum persistency at the individual firm level. We find that, consistent with the delayed
reaction hypothesis, winner and loser stocks with a higher level of information asymmetry or higher
degree of heterogeneous beliefs tend to stay in their respective portfolios in the next formation period.
In addition, those persistent portfolios with higher levels of information asymmetry or higher degrees
of heterogeneous beliefs can generate more momentum profits in the subsequent 1-year holding period.
We further conduct a duration model to investigate whether characteristics associated with
information asymmetry and heterogeneous beliefs can affect winner and loser durations. We show that
persistent winners and losers of relatively small size, with highly idiosyncratic volatility and low
institutional ownership, will have a longer duration as winners (losers). The finding implies that
investors tend to underreact to information about firms with greater information asymmetry, leading to
a longer momentum effect. In addition, the positive association among the duration, trading volume,
and dispersion of analyst forecasts indicates that momentum stocks endure longer if investor opinions
differ about their fundamental value. We also observe a strong momentum persistency for
high-information asymmetry and high-heterogeneous belief stocks that exhibit a large price
appreciation (depreciation). That is, the momentum effect is more persistent when stocks have more
incremental information content during the formation period and those prices thus do not reflect this
information efficiently. In addition, the duration model shows an asymmetric effect on momentum
duration: the formation-period return plays a relatively important role for persistent losers, but the post-
formation return is more important for persistent winners.
Overall, this study contributesto the finance literature in several ways. First, we provideevidence of
the implementationcost of the momentum strategy.Knez and Ready (1996), Shleiferand Vishny (1997),
Grundy andMartin (2001), Korajczyk and Sadka(2004), and Israel and Moskowitz (2013)argue that the
trading costmay deter investors from applying the momentumstrategy, though the effect of tradingcosts
cannot fully explain momentum profits. The current study demonstrates a large dispersion of post-
formation returns and a highturnover rate for winner and loser portfolios, indicating that not all winner
and loser stocks follow the midterm return continuation. The momentum strategy contains an
implementationrisk: investors could face a potential loss if they cannot go long for all winner stocksand
go short for all loserstocks. Such an indirect implementation cost for the momentumstrategy is new to the
literature and presents a possible avenue to track the sources of the momentum effect.
Second, we find a stronger post-formation performance for persistent momentum portfolios and
demonstrate that the persistent momentum effect cannot be explained by risk factors. Prior literature

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