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Market states and momentum in sector exchange-traded funds

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Abstract

We provide a clean out-of-sample test of momentum effects by focusing on a new sample period and a new set of test assets. More specifically, we examine market states and momentum in sector exchange-traded funds (ETFs) in the post-2000 period. Our results suggest that there is no momentum in sector ETFs, and that momentum does not depend on market states in the recent decade. Our findings have important theoretical as well as practical implications. In terms of theoretical implications, models attempting to explain momentum now have a higher hurdle to meet in that these models need to explain why momentum does not seem to exist in the recent decade. In terms of practical implications, our findings suggest that in capital budgeting, portfolio evaluation, investment and risk analysis decisions, caution should be exercised in using the models that take into account momentum effects.

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Notes

  1. For more momentum evidence, see also Rouwenhorst (1998), Moskowitz and Grinblatt (1999), Chan et al (2000), Hong et al (2000), Lee and Swaminathan (2002), Jegadeesh and Titman (2001), Du and Denning (2005), Hvidkjaer (2006), Avramov et al (2007), Du and Watkins (2007), Du (2008), Garlappi and Yan (2011), Moskowitz et al (2012) and Asness et al (2013).

  2. Although mean returns of these ETFs are insignificant, there may still be momentum, because momentum has multiple sources. As Lewellen (2002) points out, ‘momentum is a cross-sectional result (winners beat losers) … Intuitively a stock that outperformed other stocks in the past might continue to do so for three reasons: (1) the stock return is positively autocorrelated, so its own past return predicts high future returns; (2) the stock return is negatively correlated with the lagged returns on other stocks, so their poor performance predicts high future returns; and (3) the stock simply has a high unconditional mean relative to other stocks’ (p. 534) Therefore, even if mean returns of test assets are all zero, momentum can still exist due to autocorrelation or cross-serial correlation. Empirically, Jegadeesh and Titman (2002) find that momentum in individual stock returns is not due to dispersion in unconditional mean returns.

  3. In the robustness checks section, we report the results based on the 6-month holding period as well as those based on the strategies that buy top three and sell bottom three ETFs.

  4. We thank Fama and French for making these data available at mba.tuck.dartmouth.edu/pages/faculty/ken.french/.

  5. In the robustness check section, we also report the results based on prior 1 year.

  6. We also repeat the tests by buying the top two ETFs and selling the bottom two ETFs. Again, the results are similar, and are available upon request.

  7. We also repeat the tests with the market state identified by prior 2-year market return. Again, the results are similar, and are available upon request.

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Authors and Affiliations

  1. Department of Economics, Finance and International Business, Silberman College of Business, Fairleigh Dickinson University, Teaneck, NJ 07666, USA

    Karen Craft Denning

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  1. Ding Du
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  2. Karen Craft Denning
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  3. Xiaobing Zhao
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2PhD, is a Professor of Finance at Silberman College of Business, Fairleigh Dickinson University. She was educated at Cornell University and at Katz Graduate School of Business, the University of Pittsburgh. Her specialties are investment analysis and corporate finance and she has authored over 30 papers and presented many national and international conference research presentations. She has received an American Association of Individual Investors Best Paper Award. She is currently on the Board of Directors of the Eastern Finance Association and serves on an investment advisory committee for a large non-profit portfolio.

3received her PhD degrees from Nankai University, China and West Virginia University in 1999 and 2004, respectively. She is currently an Associate Professor of Economics in the W.A. Franke College of Business at Northern Arizona University. She teaches macroeconomics, environmental and natural resource economics, quantitative methods, and so on. Her research applies economic theory and finance to climate change mitigation/adaptation strategies and natural resource conservation. She has published in Ecological Economics, Ecological Modeling, Journal of Economics and Business, Review of Quantitative Finance and Accounting and so on. She received several teaching and research awards from the college and University.

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Du, D., Craft Denning, K. & Zhao, X. Market states and momentum in sector exchange-traded funds. J Asset Manag 15, 223–237 (2014). https://doi.org/10.1057/jam.2014.24

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