Momentum Trading, Return Chasing, and Predictable Crashes

We combine self-collected historical data from 1867 to 1907 with CRSP data from 1926 to 2012, to examine over 140 years of risk and return of one of the most popular mechanical trading strategies?momentum. We find that the momentum strategy has earned abnormally high risk-adjusted returns?a three factor alpha of 1 percent per month between 1927 and 2012 and 0.5 percent per month between 1867 and 1907?both statistically significantly different from zero. However, the momentum strategy also exposed investors to large losses (crashes) during both periods. Momentum crashes were predictable. Crashes were more likely when momentum had recently performed well (both eras), interest rates were relatively low (1867?1907), or momentum had recently outperformed the stock market (CRSP era) - times when borrowing or attracting return chasing ?blind capital? would have been easier. We argue based on a stylized model and simulated outcomes from a richer model that a money manager who competes for funds from return-chasing investors and is compensated via fees that are convex in the amount of money managed and the return on that money has an incentive to remain invested in momentum even when the crash risk is known to be high.