The Rodney L. White Center for Financial Research The Cost of Trend Chasing and the Illusion of Momentum Profits

There is a large and growing literature documenting the relation between ex ante observable variables and stock returns. Importantly, much of the evidence on the relation between returns and observable variables like market capitalization, the ratio of price/book, and prior price change has been portrayed in the context of returns to simulated portfolio strategies. Often missing in these analyses is the distinction between realizable returns (i.e., the returns portfolio managers can realistically achieve in practice) and returns to simulated strategies. There is ample evidence that size and value strategies can be successfully implemented in practice; that is not the case for momentum strategies. This paper documents the costs of implementing actual momentum strategies. I examine the trade behavior, and the costs of those trades, for three distinct investor styles (momentum, fundamental/value, and diversified/index) for 33 institutional investment managers executing trades in the U.S. and 36 other equity markets worldwide in both developed and emerging economies. The results show: (1) that momentum traders do indeed condition their trades on prior price movements; and (2) that costs for trades that are made conditional on prior market returns are significantly greater than for unconditional costs, especially for momentum traders. The evidence that we report on the actual costs of momentum-based trades indicates that the returns reported in previous studies of simulated momentum strategies are not sufficient to cover the costs of implementing those strategies.