Why does the momentum factor work, and is it truly an anomaly or just compensation for risk?

Question

AcadiFi · Accepted Answer

The momentum factor is one of the most robust empirical findings in finance — and also one of the hardest to explain within traditional efficient market theory.

**What Momentum Is:**
Stocks that have outperformed over the past 6-12 months tend to continue outperforming over the next 3-6 months. Conversely, past losers tend to keep underperforming. A typical momentum strategy goes long the top decile of 12-month returns (excluding the most recent month) and shorts the bottom decile.

**Historical Performance:**
Academic research by Jegadeesh and Titman documented that a US momentum strategy generated approximately 1% per month excess return from 1965-2000. The effect has been found in virtually every equity market globally.

**Competing Explanations:**

**1. Behavioral (Underreaction)**
- Investors are slow to update beliefs when new information arrives
- Confirmation bias causes them to under-weight evidence that contradicts their existing view
- Prices adjust gradually rather than instantaneously, creating trends

**2. Behavioral (Overreaction / Feedback)**
- Initial price moves attract trend-followers who amplify the move
- Herding behavior pushes prices beyond fundamental value
- Eventually the overreaction corrects — explaining why long-horizon momentum reverses

**3. Risk-Based**
- Momentum stocks may be riskier in ways not captured by standard models
- They tend to have high market beta during crashes ('momentum crashes' like 2009)
- The premium may be compensation for crash risk

**4. Structural / Limits to Arbitrage**
- High turnover makes momentum expensive to implement (transaction costs, taxes)
- Short-selling constraints limit arbitrage on the short leg
- Capacity constraints — too much capital chasing momentum erodes returns

**Example:** In Q1 2026, suppose the top-performing sector was semiconductors (up 22%) and the worst was utilities (down 5%). A momentum strategy would overweight semiconductors and underweight utilities going into Q2. If the trend continues, the strategy profits. But if a sudden macro shock causes a rotation, the strategy suffers a 'momentum crash.'

**Exam Perspective:** For CFA Level I, the key distinction is between behavioral and risk-based explanations. The curriculum tends to present momentum as evidence that markets are not perfectly efficient in the short term, but acknowledges that crash risk partially explains the premium.

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Why does the momentum factor work, and is it truly an anomaly or just compensation for risk?

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