The momentum strategy is as follows: Step 1. Take a large group of traded securi
ID: 2792885 • Letter: T
Question
The momentum strategy is as follows: Step 1. Take a large group of traded securities (ex: those in the S&P; 500 Index) and rank the securities by their return over the last 6 months; let those securities in the top 10% of the group be called "winners" and let those securities in the bottom 10% be called “losers". Step 2. Short all the loser securities and use the proceeds from the short sales to buy all of the winner securites; hold this portfolio for 6 months. . At the end of the 6 month holding period, start over with step 1. That is rank securities by return and redefine the winner and loser securities. Step 4. Based on the new winners and losers, redo step 2. Step 5. Keep doing this over and over every 6 months. The "momentum" strategy has been shown to generate expected returns in excess of those implied by CAPM. So the return on the momentum strategy generates greater returns on average than those which should be paid given the riskiness of momentum returns. 1. What does the profitability of the momentum strategy imply about the information efficiency of the market? 2. Which form or forms of the Efficient Hypothesis is/are violated (if any)? Explain why.Explanation / Answer
1. Profitability of the momentum strategy implies that lack of information efficiency in the market. This is because investors following this strategy are able to make higher-than-risk-adjsuted returns (based on the CAPM). Such a situation would not have been possible if there was a high degree of information efficiency in the market and the returns in that case would be as implied by the CAPM.
2. Momentum strategy is a form of technical trading. It therefore violates all form of Efficient Market Hypotheses (EMH) i.e. Weak, Semi-Strong and Strong.
Even the weak form of EMH states that technical analysis cannot deliever superior returns which is clearly not the case here.
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