Does Momentum Explain Most Asset Pricing Anomalies?

Financial researchers have assembled a small library of empirical support for explaining the existence of excess return over a relevant benchmark as the byproduct of one or more asset pricing anomalies. The factor zoo, as it’s derisively called, now ranges from the well-known value and small-cap risk premia to hundreds of lesser-known anomalies.

By this reasoning, the simplicity of the capital asset pricing model’s single-beta mapping has given way to a multi-dimensional universe of empirical risk factors a la the arbitrage pricing theory. That implies greater opportunity but also greater potential for trouble since the relationship is weak, at best, between portfolio-design complexity and higher risk-adjusted return.

“The rate of factor production in the academic research is out of control,” complain professors Campbell Harvey (Duke) and Yan Liu (Purdue) in “A Census of the Factor Zoo.” They recently counted over 400 factors identified in papers published in leading academic journals over the last several decades.  The authors note that if this trend were to continue until 2037, the factor zoo would be inhabited by nearly 800 inmates. An exceptional run of intellectual productivity, to be sure, but “surely, many of them are false,” they grumble.

Regardless of the actual number, deciding how to analyze, build and monitor portfolios could overwhelm even the most enlightened investor if, in fact, there are a myriad of risk factors impacting portfolio returns. Rebalancing, for instance, is far less intuitive and subject to much greater uncertainty than standard theory suggests, even if the true number of relevant factors is a relatively light dozen or so.  

But a recent study suggests explaining portfolios from a risk perspective may be less complicated than the surge of reported anomalies research suggests. Momentum, a pair of academics advise, appears to explain many risk anomalies for equity investing. Or as they put it in the paper’s title: “One anomaly to explain them all.”

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