Working Paper: CEPR ID: DP10234
Authors: Benjamin Chabot; Eric Ghysels; Ravi Jagannathan
Abstract: We combine self-collected historical data from 1867 to 1907 with CRSP data from 1926 to 2012, to examine over 140 years of risk and return of one of the most popular mechanical trading strategies?momentum. We find that the momentum strategy has earned abnormally high risk-adjusted returns?a three factor alpha of 1 percent per month between 1927 and 2012 and 0.5 percent per month between 1867 and 1907?both statistically significantly different from zero. However, the momentum strategy also exposed investors to large losses (crashes) during both periods. Momentum crashes were predictable. Crashes were more likely when momentum had recently performed well (both eras), interest rates were relatively low (1867?1907), or momentum had recently outperformed the stock market (CRSP era) - times when borrowing or attracting return chasing ?blind capital? would have been easier. We argue based on a stylized model and simulated outcomes from a richer model that a money manager who competes for funds from return-chasing investors and is compensated via fees that are convex in the amount of money managed and the return on that money has an incentive to remain invested in momentum even when the crash risk is known to be high.
Keywords: limits to arbitrage; momentum
JEL Codes: G1; G12; G14
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| managerial incentives (M52) | investor behavior (G41) |
| return-chasing behavior (C92) | crowded trades (F19) |
| crowded trades (F19) | crash risk (G01) |
| momentum strategy performance (C69) | systemic risk in momentum trading strategies (E44) |
| momentum strategy performance (C69) | crash probability (G01) |
| momentum strategy performance (C69) | large losses during predictable crash periods (G01) |
| low interest rates (E43) | return-chasing behavior (C92) |