Crash Sensitivity Explains the Momentum Effect in Stocks
Related mainly to equity based momentum strategies:
Authors: Ruenzi, Weigert
Title: Momentum and Crash Sensitivity
This paper proposes a risk-based explanation of the momentum anomaly on equity markets. Regressing the momentum strategy return on the return of a self-financing portfolio going long (short) in stocks with high (low) crash sensitivity in the USA from 1963 to 2012 reduces the momentum effect from a highly statistically significant 11.94% to an insignificant 1.84%. We find additional supportive out-of sample evidence for our risk-based momentum explanation in a sample of 23 international equity markets.
Notable quotations from the academic research paper:
"Although momentum is widely documented on financial markets, there is still an active ongoing debate about its main drivers and determinants. While most studies advocate a behavioral explanation for the effect, i.e., momentum is driven by either overreaction or underreaction of investors, recent studies point out the riskiness of momentum strategies.
Motivated by these recent results, we investigate whether momentum profits are driven by exposure of the momentum strategy to a systematic crash risk factor. Specically, we regress the momentum portfolio long-short return (UMD) on the return of a self-financing portfolio that buys stocks with high crash sensitivity and sells stocks with low crash sensitivity (CRASH) on the US stock market in the period from 1963 to 2012. The crash sensitivity of individual stocks is measured based on the lower tail dependence of their return time series with the market return time series (see Chabi-Yo, Ruenzi, and Weigert, 2017). Our results indicate that the momentum strategy loads significantly positive on the crash sensitivity factor. While simultaneously controlling for the Fama and French (1993) factors, we show that including the crash sensitivity factor as an explanatory variable for the momentum return reduces its annualized alpha from a statistically significant 11.94% to an insignificant 1.84%, i.e., a percentage decrease of almost 85%.
As an out-of-sample check we also examine the relationship between the momentum return and the crash sensitivity factor on 23 international equity markets. We find that in 22 countries (i.e., in all countries except of Singapore) momentum loads positively on systematic crash sensitivity with corresponding statistical significance (at least on the 10% level) in 13 countries. Including the crash sensitivity factor as an explanatory variable in the regression setup lowers the alpha of momentum returns in 22 countries and enhances the adjusted R-square in 20 countries of our international sample. Overall, our findings show that at least a substantial part of U.S. and international momentum profits represents a risk premium for the exposure of the strategy to systematic crash risk."
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