Does a stock momentum strategy selecting only persistent winners and losers work better than a conventional strategy that includes one-month wonders? In their August 2015 paper entitled “Persistency of the Momentum Effect: The Role of Consistent Winners and Losers”, Hong-Yi Chen, Pin-Huang Chou and Chia-Hsun Hsieh examine stock momentum persistence as a condition for momentum portfolio construction. They define the momentum of a stock as persistent if it appears in the top or bottom tenth (decile) of ranking interval returns for at least two consecutive months. They determine what kinds of stocks tend to exhibit momentum persistence. They also investigate whether restricting momentum portfolios to persistent winners and losers improves performance compared to a conventional momentum portfolio. While considering several ranking intervals, they focus on six months. Using firm accounting information (lagged at least six months), stock trading data and quarterly institutional holdings for a broad sample of U.S. common stocks during 1980 through 2011, they find that:
- For a six-month ranking interval, 47% of all winner (loser) stocks exit the winner (loser) decile the next month.
- Consistent winners and losers exhibit higher subsequent momentum than inconsistent winners and losers. This difference in post-formation performance lasts more than six months.
- Momentum persistence is associated with small size, high idiosyncratic risk (volatility), low institutional ownership, high dispersion of analyst forecasts and high trading volume. These relationships suggest that persistence derives from information asymmetry and disagreement about a stock.
- A momentum strategy that selects stocks with past persistent momentum outperforms a conventional momentum strategy.
- A strategy that is long (short) the equally weighted stocks in the top (bottom) decile of past returns for two consecutive monthly six-month ranking intervals, with a skip-month between the second ranking interval and portfolio formation, generates an average gross monthly return of 1.25% over the next six months (about 15% annualized).
- A conventional momentum strategy based only on the second of the two consecutive ranking intervals generates an average gross monthly return of 1.06% over the next six months.
- Outperformance of the persistent momentum strategy survives control for market, size, book-to-market, momentum and liquidity factors.
In summary, evidence indicates that investors may be able to boost performance of a stock momentum strategy by restricting consideration to stocks that are winners for losers for at least the last two consecutive monthly ranking iterations.
Cautions regarding findings include:
- Reported returns are gross, not net. Accounting for portfolio reformation frictions and shorting costs would reduce these returns. Shorting may not be feasible for some loser stocks.
- The authors note that portfolio turnover is lower for stocks with persistent momentum than for one-month wonders. However, based on their characteristics, stocks in persistent momentum portfolios may bear higher trading frictions on average than those in conventional momentum portfolios.
- The study considers many momentum strategy variations applied to the same sample, introducing data snooping bias, such that the best-performing strategies likely overstate expectations.
- Testing variations of the momentum strategy on stock samples similar to those used in prior research adds to the aggregate snooping bias in the body of known research. To address this bias, investors should consider setting a high bar for “better” when evaluating new strategy variations.
