Are Value Investing and Momentum Investing Robust Anomalies?

/Are Value Investing and Momentum Investing Robust Anomalies?

Are Value Investing and Momentum Investing Robust Anomalies?

Beating a Dead Horse: Value investing and momentum investing work

At this stage in our lives we’ve essentially memorized the CRSP/Compustat database. Name an anomaly and we can probably tell you the stats on it fairly quickly.

Legitimate anomalies can usually be described via a behavioral finance lens:

  1. Can we identify poor psychology in the market? (Why do prices get dislocated along the way)
  2. Can we identify the limits to arbitrage? (Why don’t large pools of capital arbitrage the anomaly away)

There are 2 anomalies that stand out among all other anomalies: Value investing and momentum investing.

But don’t take our word for it, check out one of my favorite papers on the subject of “anomaly chasing:”

…and the Cross-Section of Expected Returns

The results are hypothetical results and are NOT an indicator of future results and do NOT represent returns that any investor actually attained. Indexes are unmanaged, do not reflect management or trading fees, and one cannot invest directly in an index. Additional information regarding the construction of these results is available upon request.

The results are hypothetical results and are NOT an indicator of future results and do NOT represent returns that any investor actually attained. Indexes are unmanaged, do not reflect management or trading fees, and one cannot invest directly in an index. Additional information regarding the construction of these results is available upon request.

You can find the entire laundry list of the papers examined here.

The authors argue that published papers suffer from serious data-mining efforts, and therefore, we need to adjust our statistical inference metrics to account for this fact.

We 100% agree with this insight.

And after considering this “high-bar,” there are only 3 anomalies that withstand the test of time: Value, Momentum, and Durable Consumption Goods (DCG). Value and momentum we know and love, whereas, DCG, while interesting, is a questionable strategy based on our internal research. (one can get the data here)

Perhaps more interesting is the fact that 300+ “anomalies” identified in the academic literature, once adjusted for data-mining, don’t pass the gauntlet. You’ll also notice that many of these strategies are wrapped in “smart beta” wrappers in the current marketplace.

Some examples:

  • Dividend Yield
  • Size
  • Sentiment
  • Liquidity
  • Profitability
  • Volatility
  • Carry
  • Beta

Are you buying a backtest? Or are you buying a sustainable alpha process?

  • The views and opinions expressed herein are those of the author and do not necessarily reflect the views of Alpha Architect, its affiliates or its employees. Our full disclosures are available here. Definitions of common statistics used in our analysis are available here (towards the bottom).
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About the Author:

Wes Gray
After serving as a Captain in the United States Marine Corps, Dr. Gray earned a PhD, and worked as a finance professor at Drexel University. Dr. Gray’s interest in bridging the research gap between academia and industry led him to found Alpha Architect, an asset management that delivers affordable active exposures for tax-sensitive investors. Dr. Gray has published four books and a number of academic articles. Wes is a regular contributor to multiple industry outlets, to include the following: Wall Street Journal, Forbes,, and the CFA Institute. Dr. Gray earned an MBA and a PhD in finance from the University of Chicago and graduated magna cum laude with a BS from The Wharton School of the University of Pennsylvania.
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  • Paul Novell

    AQR would argue that size is durable once adjusted for junk as the title of one of their recent papers suggests.

  • Jack Vogel, PhD

    True, but that involves combining multiple factors.

  • Paul Novell

    Very true.

  • Another excellent post.

    “If we can’t identify the psychology behind a strategy and the limits of arbitrage (which is relatively straight forward with value/momentum)…”

    Straightforward for you! I can’t do this off the top of my head and found allusions but not a packaged argument on your site. Any chance of a link?

  • Jack Vogel, PhD
  • Brilliant! Many thanks. JB

  • IlyaKipnis

    Not sure about DCG myself, either. I see it as perhaps some sort of “low volatility” anomaly type of thing? That is, even if the economy is poor, it isn’t like people are going to buy a car when they don’t need one in a good economy, and if their car gets totaled in a bad economy, they’ll need a new one. Though I suppose I have a hard time reconciling that hypothesis with all of the advertising for big ticket items during the holiday season (EG one of the few times I may watch TV is the NFL playoffs).

    Just a thought.

  • jimhsu

    Having read half of your blog as well as Quantitative Value, I think it’s time I combined it with my interest in neuroscience and write something up. A write-up that I posted:

    On Value and Growth – Why Investors Get it Wrong

    I believe a large portion of investor underperformance is due to timeframe inversion in allocating between momentum (“growth”) and reversion (“value”).

    Behavioral psychology postulates that humans strongly prefer avoiding losses to acquiring gains (loss aversion: ). However in the realm of guaranteed losses, humans prefer to take a chance at no loss vs. a smaller guaranteed loss, even if the expected returns are the same, according to prospect theory ( ) [risk-seeking]. The inverse happens with guaranteed gains; investors prefer to take the a guaranteed gain as opposed to a slightly smaller probability of a larger gain, even if the expected returns are the same [risk-averse].

    First, looking at momentum: momentum by definition is a short-term phenomenon (academic studies use a monthly rebalance with the classic 12-2 month averaged returns as a momentum benchmark, although Jegadeesh/Titman 2001 ( ) show that the effect persists for up to 1 year, but not beyond that). Gains on momentum positions please investors, when the rational thing to do would be to be more skeptical (in other words, investors suffer from confirmation bias). Indeed Smith et al 2014, PNAS ( ), shows that financial bubbles cause activation of specific brain regions; specifically, the lowest earners have increased activation of the nucleus accumbens (motivation, reward learning), while the highest earners counter-intuitively have increased activation of the anterior insular cortex (associated with, most strongly, emphatic pain perception), which projects to the amygdala (the classic “fear” center).

    As momentum mean-reverts due to the laws of price gravity, the confirmation bias remains, and investors remain locked in their now rapidly declining positions. Greed turns to fear, then despondency, then apathy. Facing a guaranteed loss, investors choose to “wait it out further” at a chance of recouping the losses, according to prospect theory. At the worst possible time, the decision is finally made to exit and relieve the accumulated emotional pain; this typically corresponds to market bottoms.

    For value: value is a long-term phenomenon (studies typically use an annual rebalance, although the value effect persists for up to 5 years). Value is classically taking advantage of mean-reversion; however within long-term mean reversion lies the combined effects of high volatility (value assets usually have strongly negative corporate/industry/geopolitical news), combined with negative momentum (coming from investors bailing out of their momentum positions, and is especially potent). In the context of unfavorable news streams as well as high volatility, “bottom-fishing” investors are content to take gains early, even if the value of the asset has not appreciably changed, and this causes pullbacks, some which can be violent. (As above, investors prefer to take a guaranteed gain as opposed to a lower probability of a higher gain, even if the latter produces a higher expected return). As a sidenote, these “bottom-fishing” investors also (mis)identify value in collapsing momentum assets, and this is the cause of violent bull-market rallies in declining bear markets. Hence, investors bail on value strategies on small gains and losses, and do not realize large amounts of alpha which comes from holding value positions for an extended amount of time.

    In summary: investors think “long-term” for momentum strategies when they should be thinking short-term. Just the opposite for value.