An Adverse-Selection Explanation of Momentum: Theory and Evidence

Abstract

This paper rationalizes momentum in a competitive market with information asymmetry and fixed transaction costs. The existence of a fixed cost per transaction faced by uninformed investors hampers information revelation through price and induces further adverse selection in quantity. The adverse selection in quantity drives a wedge between returns inferred from observable prices and returns obtained by an uninformed investor. This discrepancy becomes most pronounced when information asymmetry accompanies unbalanced non-information-driven trades. Momentum thus arises when uninformed investors accommodate sells (buys) by informed investors who unwind their positions upon the realization of strong (weak) stock performance. Properly adjusting stock returns for adverse selection by using data on trading volume substantially mitigates momentum-based arbitrage profits for the sample period from 1983 to 2004. In addition, an empirical proxy for exploitable information asymmetry forecasts the strength of momentum for extreme performers in the recent past.