Markus Baltzer, Stephan Jank, and Esad Smajlbegovic contributed to the literature on momentum, as well as the tendency for momentum to have crashes, with their 2014 study, a Bundesbank Discussion Paper, Who Trades on Momentum?
The authors begin their analysis by noting: “Not all investors can simultaneously follow the momentum strategy. Market clearing condition dictates that for every buyer, there must be a seller. If one investor buys winners and sells losers, another investor has to sell winners and buy losers.” Using a unique set of data on the German stock market (the seventh largest in the world) that covered the period from 2006 through 2012, Baltzer, Jank, and Smajlbegovic examined the investment decisions of various investor types before, during, and after the 2008-2009 financial crisis. By observing the entire ownership structure of the market, they were able to determine who trades on momentum and which investors are on the other side. The following is a summary of their findings:
- Financial institutions, in particular mutual funds and foreign investors (also generally institutional investors), are momentum traders, while private households are instead contrarians. The data was statistically significant at the 1% confidence level.
- When looking at winner and loser stocks separately, momentum trading is particularly strong among loser stocks.
- The degree of contrarian trading is negatively correlated with individual investors’ level of sophistication. In other words, the more sophisticated the investor, the less contrarian the behavior exhibited. As proxies for investor sophistication, the authors employed two metrics commonly used in the literature: investors’ average financial wealth and home-country bias. As financial wealth increased and home-country bias decreased, the contrarian behavior decreased. In short, the lack of financial sophistication is costly.
- Aggregate momentum trading in the market is anti-cyclical. It increases during market downturns and in high-volatility phases.
- When separating winner and loser stocks, only the sale of loser stocks increases during bad economic states, while the purchase of winner stocks is largely unrelated to the business cycle, the state of the market, or volatility.
- Strong (increased) previous momentum trading negatively predicts future momentum profits. Excessive selling of loser stocks by institutions predicts reversals of the momentum strategy.
Excessive selling of loser stocks by institutions predicts reversals of the momentum strategy.
Another interesting, although unrelated, finding was that private households (i.e., the less sophisticated investors) show a strong preference for high-dividend stocks.
The authors went on to note their finding that “private investors are strongly contrarian is consistent with evidence that investors prone to the disposition effect (private investors) generate price distortions, underpricing winners and overpricing losers, which in turn are exploited by rational investors (institutional and foreign investors).”
The disposition effect is the tendency for individuals to hold onto losing stocks for too long and sell winners too soon, thereby creating selling pressure for winner stocks and buying pressure for loser stocks. This demand distortion leads to an information underreaction, where winners are undervalued and losers overvalued. Rational investors exploit this mispricing, but, due to limits to arbitrage, the prices only converge slowly, giving rise to momentum profits.
Additionally, the authors cited prior research showing that “arbitrageurs try to exploit underreactions to news by other investors. However, excessive momentum trading in the market can lead to an overreaction of arbitrageurs, pushing prices above/below their fundamental values and leading to a (long-term) reversal of returns.” Their evidence regarding the excessive sales of loser stocks by institutional investors followed by the momentum reversal in 2009 is consistent with the prior research.
The authors write, “Particularly, we find that the sale of loser stocks by institutions and foreign investors in bad economic states forecasts reversals in the momentum strategy.” Finally, they concluded, “Momentum trading in the loser portfolio increases during market downturns and volatile times and also forecasts momentum returns thus contributes to research into time-varying momentum profits.”
This, too, is consistent with prior research showing that the profitability of momentum strategies is time-varying. Periods of high volatility tend to lead to crashes (on the short side of momentum). This finding has led to strategies that scale momentum. For example, fund manager AQR Capital incorporates the scaling of momentum into its strategies. Their long-only funds do not scale momentum exposure, but their long-short funds (such as their Style Premia funds like QSPRX do). The reason for the difference in strategies is that the short side of momentum is the one subject to crashes. AQR scales momentum by targeting specific levels of volatility, investing fewer dollars when markets are more volatile and more dollars when markets are less volatile.
Summary
Behavior resulting from the disposition effect can generate negative aggregate demand for past winners and positive aggregate demand for past losers. And institutions exploit this behavior. But it’s important to keep in mind, at least for those using long-short momentum strategies, that the increased sales of losing stocks during periods of heightened volatility have been shown to result in increased risk of momentum crashes (on the short side). Thus, investors using a long-short strategy should consider scaling their exposure.
Full disclosure: My firm, Buckingham, recommends AQR funds in constructing client portfolios.