International momentum strategies: a stochastic dominance approach

Abstract This paper applies recent econometric tests of stochastic dominance to examine an enduring puzzle in finance: the momentum effect in stock returns (J. Finance 48 (1993) 65). We use stochastic dominance tests to distinguish between the hypothesis that there exists general asset pricing models that can explain momentum versus the alternative hypothesis that there are no asset pricing models consistent with risk-averse investors that can rationalize that effect. Using stock index data for 24 countries over the period 1989–2001, we show that winner portfolios stochastically dominate loser portfolios at second and third order. These results are robust to two subperiods with different risk and return characteristics and survive reasonable transaction costs for international index funds. Our results indicate that the search for rational asset pricing explanations for the momentum effect may be a futile one.

[1]  Josef Lakonishok,et al.  Momentum Strategies , 1995 .

[2]  Tae Kun Seo,et al.  Admissible Sets of Utility Functions in Expected Utility Maximization , 1978 .

[3]  Terence Lim,et al.  Bad News Travels Slowly: Size, Analyst Coverage and the Profitability of Momentum Strategies , 1998 .

[4]  Stephen G. Donald,et al.  Consistent Tests for Stochastic Dominance , 2003 .

[5]  M. Rothschild,et al.  Increasing risk: I. A definition , 1970 .

[6]  E. Fama,et al.  Multifactor Explanations of Asset Pricing Anomalies , 1996 .

[7]  M. Petersen,et al.  Posted versus effective spreads: Good prices or bad quotes? , 1994 .

[8]  Bruce D. Grundy,et al.  Understanding the Nature of the Risks and the Source of the Rewards to Momentum Investing , 1998 .

[9]  Michael J. Cooper,et al.  Market States and Momentum , 2004 .

[10]  K. Rouwenhorst.  Local Return Factors and Turnover in Emerging Stock Markets , 1998 .

[11]  Tarun Chordia,et al.  Momentum, Business Cycle and Time Varying Expected Returns , 2001 .

[12]  J. Stein,et al.  A Unified Theory of Underreaction, Momentum Trading and Overreaction in Asset Markets , 1997 .

[13]  Robert A. Korajczyk,et al.  Are Momentum Profits Robust to Trading Costs? , 2003 .

[14]  D. Hirshleifer,et al.  Feedback and the Success of Irrational Investors , 2003 .

[15]  R. Engle,et al.  Pricing Exchange Traded Funds , 2002 .

[16]  Stephen E. Wilcox.  Investor Psychology and Security Market Under- and Overreactions , 1999 .

[17]  H. Levy.  Stochastic dominance and expected utility: survey and analysis , 1992 .

[18]  G. Whitmore,et al.  Third-Degree Stochastic Dominance , 1970 .

[19]  H. Levy.  Upper and Lower Bounds of Put and Call Option Value: Stochastic Dominance Approach , 1985 .

[20]  Gautam Kaul,et al.  An Anatomy of Trading Strategies , 1998 .

[21]  Narasimhan Jegadeesh,et al.  Returns to Buying Winners and Selling Losers: Implications for Stock Market Efficiency , 1993 .

[22]  H. Nejat Seyhun,et al.  Can Omitted Risk Factors Explain the January Effect? A Stochastic Dominance Approach , 1993, Journal of Financial and Quantitative Analysis.

[23]  W. R. Russell,et al.  Representative Sets for Stochastic Dominance Rules , 1989 .

[24]  Jennifer Conrad,et al.  Profitability of Momentum Strategies: An Evaluation of Alternative Explanations , 2001 .

[25]  P. Fishburn.  Stochastic Dominance in Nonlinear Utility Theory , 1989 .

[26]  Prospect Theory and Asset Prices , 1999 .

[27]  John M. Griffin,et al.  Momentum Investing and Business Cycle Risk: Evidence from Pole to Pole , 2001 .

[28]  D. McFadden.  Testing for Stochastic Dominance , 1989 .

[29]  Charles Trzcinka,et al.  A New Estimate of Transaction Costs , 1999 .

[30]  Kent D. Daniel,et al.  Chapter 13. Investor Psychology and Security Market Under- and Overreaction , 2005 .

[31]  Michael J. Schill,et al.  The Illusory Nature of Momentum Profits , 2004 .

[32]  Xibin Zhang,et al.  Australia Department of Econometrics and Business Statistics a Monte Carlo Investigation of Some Tests for Stochastic Dominance a Monte Carlo Investigation of Some Tests for Stochastic Dominance , 2022 .

[33]  R. Davidson,et al.  Statistical Inference for Stochastic Dominance and for the Measurement of Poverty and Inequality , 1998 .

[34]  Allaudeen Hameed,et al.  Profitability of Momentum Stragegies in the International Equity Markets , 2000, Journal of Financial and Quantitative Analysis.

[35]  Narasimhan Jegadeesh,et al.  Cross-Sectional and Time-Series Determinants of Momentum Returns , 2002 .

[36]  Susan M. Mangiero.  International Momentum Strategies , 1998 .

[37]  Kent D. Daniel,et al.  Presentation Slides for 'Investor Psychology and Security Market Under and Overreactions' , 1998 .

[38]  Mark Grinblatt,et al.  Do Industries Explain Momentum , 1999 .

[39]  Thierry Post,et al.  Empirical Tests for Stochastic Dominance Efficiency , 2003 .

[40]  H. Levy,et al.  Efficiency analysis of choices involving risk , 1969 .

[41]  Josef Hadar,et al.  Rules for Ordering Uncertain Prospects , 1969 .

[42]  R. Roll,et al.  A Simple Implicit Measure of the Effective Bid-Ask Spread in an Efficient Market , 2008 .

[43]  A. Gallant,et al.  Nonlinear Statistical Models , 1988 .

[44]  Campbell R. Harvey,et al.  PREDICTABLE RISK AND RETURNS IN EMERGING MARKETS , 1999 .

[45]  H. Ury,et al.  Tables of the Studentized Maximum Modulus Distribution and an Application to Multiple Comparisons Among Means , 1979 .

[46]  Charles M. C. Lee,et al.  Price Momentum and Trading Volume , 1998 .

[47]  T. Fomby,et al.  Studies in the Economics of Uncertainty , 1989 .