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August 31, 2003

Paying a Higher Price For Momentum Trades

By John A. Byrne

Contrary to popular belief, momentum trading can incur higher average transactions costs than other strategies used by institutional investors, according to a new study.

Until recently, the gains from trading stocks that outperform the market were generally regarded as enough to offset the transaction costs. Unfortunately, these assumptions are wrong, according to Donald Keim, a finance professor at the Wharton School of the University of Pennsylvania.

His study, conducted from 1996 to 2000, used data from the Plexus Group. The study comprised 33 institutional managers, making a total of 1.6 million trades valued at some $1 trillion. Los Angeles-based Plexus divided the managers into three groups: momentum, value and hybrid. The study noted that momentum managers can move the price of stocks much more significantly than other managers. These pre-trade execution price run-ups should be included in calculating transaction costs, he said.

Indeed, momentum managers may pay a premium when buying stock and take a low price upon selling. That's because many investors do not usually want to be on the other side of these trades.

Professor Keim noted that, for the typical momentum investor in his sample the round trip transactions cost, prior to trading, comes to nearly three percent of the price of a domestic stock. That's three and a half times more than the cost for the average value manager, and nearly three times more than that for the typical manager in the hybrid group.