In the financial markets, the momentum anomaly is a phenomenon in which financial assets that have had recent positive returns tend to continue performing well, while those with recent negative returns tend to keep declining. It is also known as the ‘momentum effect’ and has been observed in stocks, commodities, currencies, and other asset classes. The momentum anomaly is considered to be one of the most consistent anomalies in finance, as it has been observed across different markets, countries, and time periods.
Reference [1] examined whether the momentum anomaly still exists in the financial markets these days. Specifically, it analyzed the performance of a momentum trading strategy where we determine each asset’s excess return over the past 12 months. If the return is positive, the financial instrument is bought, and if negative, the financial instrument is sold.
The article pointed out,
We find statistically significant evidence for the presence of the momentum anomaly in our sample period. Following the methodology of Moskowitz et al.(2012), we create a time series momentum strategy, finding that the strategy generates a Sharpe ratio of 0.75, compared to a passive long investment in the same instruments, generating a Sharpe ratio of 0.73… However, we also find overwhelming evidence of lower to zero return predictability during the last decade. When controlling three independent subperiods, we find that the strategy generates a negative alpha in the period of January 2009 to December 2021…
Finally, we find that adding drawdown control as a risk management tool enhances the strategy’s performance, both in terms of Sharpe ratio, and in terms of risk-adjusted return. The Sharpe ratio of the strategy with drawdown control is 1.07, compared to 0.75 without.
In short, the momentum anomaly is still present, but it’s getting weaker.
Our thoughts are the followings,
- The market characteristics can and will change over time
- It’s important to be able to detect when the market behaviour changes and modify the trading strategy accordingly, or even stop trading it. This is, however, not a trivial exercise.
- Using drawdown to control the risks makes sense and it seems to work.
Last and not least, if the momentum anomaly is diminishing, then will mean-reverting strategies become more profitable?
Let us know what you think in the comments below or in the discussion forum.
References
[1] David S. Hammerstad and Alf K. Pettersen, The Momentum Anomaly: Can It Still Outperform the Market?, 2022, Department of Finance, BI Norwegian Business School
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