The tendency of recent market performance to persist, an effect known as momentum, has been pervasive even though it is a “blatant violation” of what you would expect in an efficient market. This according to Alex Bryan, director of passive strategies research for Morningstar, in a recent interview.
Bryan explains that extensive research has uncovered three theories behind this:
Behavioral biases. Investors may underreact to new information because they “anchor” their investment strategies to old information. This can cause market prices to react more slowly than they should.
Investors are reluctant to sell stocks that have decreased in value. Instead, they hold onto these shares in the hopes of breaking even or even sell others that have appreciated in value to lock in gains. Again, this can lead to sluggish price corrections when new information becomes available.
Once a pricing trend has been established, investors may pile in hoping to latch on to some excess returns. This can potentially push prices away from the fair value.
Bryan says that the momentum effect is present in both the U.S. and international markets as well as across other asset classes. However, he points out that a momentum investment strategy requires high turnover (frequent rebalancing) which can create high transaction costs and decrease tax efficiency. To address this issue, Bryan suggests rebalancing quarterly rather than monthly, and/or applying the strategy at the index level. Since each index is well-diversified, he says, “you’re not having to trade in and out of as many names as if you had applied the strategy to individual stocks.”