Enhancing momentum investment strategy using leverage

• Author: Carlos Forner,Yaz Gülnur Muradoglu,Sheeja Sivaprasad
• Published date: 01 August 2018
• DOI: http://doi.org/10.1002/for.2522
• Date: 01 August 2018

RESEARCH ARTICLE

Enhancing momentum investment strategy using leverage

Carlos Forner

1

| Yaz Gülnur Muradoglu

2

| Sheeja Sivaprasad

3

1

University of Alicante, Alicante, Spain

2

Queen Mary University of London,

London, UK

3

University of Westminster, London, UK

Correspondence

Carlos Forner, University of Alicante,

Campus San Vicente del Raspeig, E‐03080,

Alicante, Spain.

Email: carlos.forner@ua.es

Abstract

Previous studies examine investment strategies based on leverage and momen-

tum; none investigates both variables jointly as an investment strategy. This

paper is the first incorporating leverage and momentum together. We show that

low past returns (losers) forecast future negative abnormal returns only among

stocks with high leverage levels, but not among stocks with low leverage levels.

However, high past returns (winners) forecast future positive abnormal returns

independently of leverage level. As a result, the negative relation between

leverage and future abnormal returns is only observed among loser stocks,

and the positive relation between past returns and future abnormal returns is

only shown among non‐low leverage stocks. Our results are important in

achieving better investment strategies: buying winners'stocks (independently

of their level of leverage) and short‐selling losers'stocks with high leverage

yield higher abnormal returns than strategies based on only one of these vari-

ables. Our two‐dimensional strategy yields risk‐adjusted abnormal returns of

15.66% per annum, whereas the single leverage or momentum strategies yield

7.70% and 7.96% per annum, respectively. The difference is nearly 8% and eco-

nomically significant. If leverage is considered as proxy for default risk, our

results, contrary to previous evidence, show that momentum profits are not

exclusive of default stocks, and that momentum returns are not only driven

by negative returns yielded by distress stocks.

KEYWORDS

distress stocks, investment strategy, leverage, momentum, nonregulated industries

1|ENHANCING MOMENTUM

INVESTMENT STRATEGY USING

LEVERAGE

Leverage and momentum have not been studied jointly in

asset pricing as the basis of abnormal returns. We bring

together two asset pricing features: returns to low leverage

firms and continuation of prior returns. The studies on

leverage do not consider momentum; likewise, the studies

on momentum do not consider leverage. It is as if these

are two separate domains in asset pricing that do not

overlap. We fill this gap and show that considering both

dimensions to construct a new strategy yields risk‐

adjusted abnormal returns of 15.66% per annum, while

the single leverage or momentum strategies yield 7.70%

and 7.96% per annum, respectively.

Modigliani and Miller (1958) show that the market

beta of equity can be decomposed into the firm's business

operation's beta (asset beta) and a factor proportional to

the firm's leverage ratio. That is, leverage amplifies the

exposure of equity to priced systematic risk. Then raw

equity returns should be positively related to leverage

because levered equity has greater sensitivity to priced

risks than unlevered equity. Accordingly, we should

Received: 20 December 2017 Accepted: 10 February 2018

DOI: 10.1002/for.2522

Journal of Forecasting. 2018;37:573–588. Copyright © 2018 John Wiley & Sons, Ltd.wileyonlinelibrary.com/journal/for 573

expect to observe higher average returns in stocks of high

leveraged firms than in stocks of low leveraged firms. Var-

ious studies have documented a positive association

between market leverage and stock returns at the firm

level: Hamada (1972), Bhandari (1988), Dhaliwal,

Heitzman, and Zhen (2006), and Gomes and Schmid

(2010). However, the empirical evidence shows a different

story when book leverage is used instead of market lever-

age. Fama and French (1992), Penman, Richardson, and

Tuna (2007), Dimitrov and Jain (2008), and Korteweg

(2010) find that book leverage is negatively associated

with returns in the USA. Strong and Xu (1997) and

Muradoglu and Sivaprasad (2012a, 2012b) find the same

negative relation in the UK stock market.

If we consider leverage to be positively related to dis-

tress risk (default probability), this negative relation is

consistent with the results that returns are lower for firms

with greater distress intensities, the so‐called “distress risk

puzzle”(Campbell, Hilscher, & Szilagyi, 2008; Dichev,

1998; Garlappi, Shu, & Yan, 2008; Griffin & Lemmon,

2002). George and Hwang (2010) analyze both leverage

and distress puzzles. They find a strong negative relation

between returns and leverage in raw returns, and an even

stronger relation in returns adjusted for risk via the Fama

and French (1993) three‐factor model (hereafter, FF).

Moreover, when leverage and distress are included in

the same regression, leverage subsumes the explanatory

power of distress in all but one of their specifications.

1

Similarly, since the work of Jegadeesh and Titman

(1993), price momentum has been studied by various

researchers as a source of abnormal returns. Momentum

refers to stocks with higher past returns (winners) over

the past 3–12 months, yielding significantly positive

abnormal returns in the next 3–12 months; and stocks

with lower past returns (losers) over the past 3–12 months,

yielding significantly negative abnormal returns in the

next 3–12 months. That is, winner stocks keep on

outperforming loser stocks for 3‐to 12‐month periods.

There is a vast literature on momentum‐based invest-

ment strategies. For instance, Jegadeesh and Titman

(2001) show that momentum profits persisted in the US

market during the 1990s. Rouwenhorst (1998) finds

evidence of momentum in a sample of 12 European

markets. Liu, Strong, and Xu (1999) find that the momen-

tum investment strategy is also profitable in the UK stock

market. Liew and Vassalou (2000), and Chui, Titman, and

Wei (2003, 2010) find that this phenomenon is observed in

global markets, with few exceptions such as Japan. Geczy

and Samonov (2016) find momentum is significant since

the beginning of the 19th century. Moreover, Fama

(1998), after a deep analysis of the robustness of the

methodologies used in the study of the different market

anomalies, concludes that only two remain unexplained:

price, and earnings momentum.

The momentum literature has also shown that this

phenomenon tends to be stronger (or exclusive) of stocks

with some characteristics. Daniel and Titman (1999) find

that momentum is bigger in growth stocks. Hong, Lim,

and Stein (2000) show that momentum decreases with

size and analyst coverage. Agarwal and Taffler (2008) find

that momentum profits are driven by the bad return

trend, earned by distress stocks. Avramov, Chordia,

Jostova, and Philipov (2007) provide evidence of momen-

tum profitability to be restricted to high credit risk firms,

and nonexistent for firms of high credit quality.

There is also extensive literature than analyses the ori-

gin of the momentum profits. On one hand, it is argued

that momentum is due to underreaction to information

(Daniel & Titman, 1999; Hong et al., 2000; Jegadeesh &

Titman, 2001; Liu et al., 1999; Mao & Wei, 2014), and on

the other hand, that it is risk related (Abinzano, Muga, &

Santamaria, 2014; Agarwal & Taffler, 2008; Avramov

et al., 2007; Booth, Fung, & Leung, 2016; Chordia &

Shivakumar, 2002; Johnson, 2002; Wu, 2002).

The purpose of this study was to examine the interac-

tion between leverage and momentum in the forecast of

future returns, and their implication in the development

of investment strategies. We find that negative abnormal

returns are exclusive for those losers'stocks that do not

have low leverage ratios. Loser stocks with low leverage

ratios overcome poor performance. On the contrary, posi-

tive abnormal returns are pervasive for all winner stocks

independently of their leverage level. Not only do winner

stocks with low leverage ratios yield positive abnormal

returns, but also winner stocks with high leverage ratios.

We also find that outperformance of low leverage stocks

over high leverage stocks is not observed among winner

stocks; and that momentum, outperformance of winner

stocks over loser stocks, is not observed among low

leverage stocks.

This interaction between past returns and leverage in

the forecast of future abnormal stock return performance

should be considered by practitioners when developing

their investment strategies in order to achieve better

results. The investment strategies that buy winners'stocks

(independently of their level of leverage) and short‐sell

losers'stocks with high leverage yield higher abnormal

returns than strategies based on only one of these

variables. For example, our two‐dimensional strategy

1

For George and Hwang (2010), these negative relations of returns with

leverage and distress are not a puzzle. They suggest that if financial dis-

tress costs heighten exposure to systematic risk that is priced, and firms

with high distress costs choose low leverage but still have greater expo-

sure to systematic risk than firms with high leverage, in this case

expected returns are greater for firms with low leverage (default proba-

bility) than firms with high leverage (default probability).

574 FORNER ET AL.