A Critique of Momentum Anomalies

Abstract

This paper is the second in a series of critiques of the assumption that stable economic relations exist between certain "firm characteristics" and expected returns. The paper explains why this is not the case for past returns and provides theoretical, empirical, and simulated evidence that the stylized facts involving momentum are consistent with traditional risk-based asset pricing, thereby solving the apparent theoretical puzzle. For example, riskier assets tend to be in the loser portfolio after (large) increases in the price of risk: The time-varying correlation between past returns and risk, which determines the risk of momentum portfolios, decreases with the price of risk. Hence, their premiums are approximately negative quadratic functions of the price of risk, theoretically truncated at zero. The best linear (CAPM) function describing this relation unconditionally has the negative slope and positive intercept documented empirically and considered the main momentum puzzle.

Keywords: momentum, risk, puzzle, ranking, conditional

JEL Classification: G11, G12, G14