“Understanding the Sources of Momentum Profits: Stock-Specific Component versus Common-Factor Component” by Qiang KANG
University of Hong Kong
This paper examines the relative importance of the stock return's stock-specific component versus its common-factor component in explaining the momentum profits. Using a model nesting both Chordia and Shivakumar~(2002) and Grundy and Martin~(2001), we demonstrate that the Fama-French three-factors model leaves out important predictive variations in stock returns needed for Chordia and Shivakumar's results. In an asset pricing model context but without reference to any particular one, we show that the predictive intercept and hence the predicted returns contain both a stock-specific component and a common-factor component. We propose a method to extract the stock-specific component from the predictive intercept and find that a momentum strategy based solely on this component generates significant profits. For robustness, we consider the Fama-French three-factors model with time-varying betas and its extended four-factors model with Pastor and Stambaugh's~(2003) liquidity factor as the fourth factor. The stock-specific component, if not the only source, appears to be a very important source of momentum profits. In various models and setups it always generates significant momentum profits in magnitude of over half of the momentum profits in stock returns. A purely risk-based theoretic model may not be able to meet the challenge.