New Light on Choice of Investment Strategy, (c) 2012 by Dimitri Vayanos and Paul K. Woolley, from the Paul.K. Wooley Center for the study of Dysfunctional Finance, London School of Economics, U.K.
A Theoretical Analysis of
Momentum and Value Strategies
LSE, CEPR and NBER
April 9, 2012‡
We explore implications of the rational theory of momentum and reversal in Vayanos and
Woolley (2011) for empirical work and portfolio management. We compute closed-form Sharpe
ratios of various implementations of momentum and value strategies, of combinations of these
strategies, and for general investment horizons. For plausible parameter values, the correlation
between momentum and value returns is negative, momentum exhibits positive serial correlation
for short lags and zero for longer lags, and value exhibits positive serial correlation for short
lags and negative for longer lags. While the Sharpe ratio for momentum exceeds that of value
for short horizons, the comparison can reverse for long horizons.