The theory works, until you factor in trading costs.

An impressive amount of academic evidence has documented the momentum phenomenon, which stubbornly defies explanation if you're a believer in efficient markets. The strategy gained great prominence in 1993 when a landmark study conducted by Sheridan Titman at the University of Texas and Narasimha Jegadeesh, who was then at the University of Illinois, suggested that maintaining a long position in past strong performers and shorting past weak performers could earn investors abnormally large returns over a six- to 12-month horizon. Since then, other research has produced similar conclusions prompting various academics to suggest that pursuing a relative-strength strategy can produce returns anywhere from 0.5% to 1.5% a month.

In theory the strategy sounds great, but now naysayers are questioning whether practical ways exist to exploit the momentum effect. In two new studies researchers, while not disputing the momentum anomaly, suggest that costs are too prohibitive to make the approach profitable for most institutional investors. Their findings conclude that any performance advantage gained by following the strategy would be swallowed, in most cases, by sizable trading costs.

One of the papers, The Illusory Nature of Momentum Profits, was written by David A. Lesmond of Tulane University, Michael J. Schill of the University of Virginia and Chunsheng Zhou of Peking University. It will be published in an upcoming issue of the Journal of Financial Economics. Donald B. Keim, a finance professor at the Wharton School at the University of Pennsylvania, authored the other, The Cost of Trend Chasing and The Illusion of Momentum Profits.

While previous studies didn't ignore transaction prices, the researchers of these latest papers suggest that transaction costs have traditionally been understated. Costs, they argue, have been downplayed in a variety of ways, including using mean commissions for New York Stock Exchange trades even though the momentum strategy is dominated by smaller, high-beta Nasdaq stocks.

What's more, a momentum strategy can require higher trading frequencies as well as shorting stocks, which is an expensive process that isn't always taken into account. In addition, stocks used in relative-strength strategies disproportionately trigger larger trading costs since momentum investors often clamor after the same equities at the same time, which reduces their liquidity and increases prices. Simultaneously, momentum traders tend to dump stocks at the very time when few investors want the dogs. Further, researchers contend it was misleading for previous academics to use average stocks, trading in average quantities, that are trending neither up nor down and that trade in markets with average liquidity.

A momentum strategy, when transaction costs aren't considered, may appear profitable, but when you take into account the total cost of trading, the momentum profits seems to be eclipsed in large part, says Lesmond, who is an assistant professor of accounting and finance.

Relying upon what they classified as "conservative" estimates of trading costs, Lesmond and his co-authors found little evidence that trading expenses generated by momentum strategies can dip below 1.5% per trade. In some cases, depending upon the momentum approach used and the size of stocks traded, the expenses were significantly higher than that.

Using a sampling period that extended from 1980 to 1998, Lesmond and his colleagues examined hypothetical trading costs derived from three relative-strength strategies chosen because of their popularity. Two of the strategies were lifted from the landmark 1993 study and Jegadeesh and Titman's later update, which documented similar findings. The third approach was borrowed from research conducted by Harrison Hong, Terence Lim and Jeremy C. Stein in 2000 that was published in the Journal of Finance. Using monthly return data from the Center for Research in Security Prices (CRSP), Lesmond and the other researchers divided the portfolios, based on gross returns, into poor, moderate and strong performers.

The study's findings illustrated that the costs of momentum trading were most prohibitive for small-cap stocks. The researchers, who used two different trading cost measures, examined the consequences of shorting the smallest small-cap losers and going long on the same pool's winners and then closing out these positions in a six-month period. The mean total costs for those four transactions would be either 12.13% or 12.92%. In contrast, the total performance return during that period was just 3.91%-a dramatic difference. When the largest and most liquid stocks were examined, the gap between costs and returns narrowed considerably, but the investor still would have lost money after costs. In this scenario costs were either 2.32% or 1.94%, which swallowed up the 1% return.

Discussing the study, Schill of the University of Virginia said the findings illustrated the futility of seeking a way to practice momentum investing while dodging prohibitive trading bills. "We suggest that if you eliminate high-trading stock costs, you eliminate the momentum trading effect," he says.

Keim suggests that what's been missing from past studies is an examination of price impacts triggered by real-life momentum trading; rather, profitability claims have been based on simulated momentum trading. "The simulated strategies are very mechanical and don't account for the impact the simulated trades would actually have on prices," Keim says. "In effect, the simulated strategies are buying and selling at prices that are not possible for actual traders. That's why it's so critical to look at the experience of actual trades."

The Wharton professor's study uses the actual costs of implementing a momentum strategy by examining more than 1.6 million institutional trades worth $1.1 trillion conducted in the Unites States and 36 other developed and emerging equity markets. These trades were placed during two 12-month periods between 1996 and 2000. Keim also compared the price tags of momentum trading with the costs generated by institutional investors pursuing either a value or diversified stock strategy.

The Plexus Group, a consulting firm that advises institutional investment managers and their traders on how to contain and control their trading costs, provided the trade data without revealing the identities of its clients.

According to Keim's study, momentum managers buying stocks in rising markets experienced a one-way average price impact of 1.89%. That means the transaction cost 1.89% more than the price of a typical retail trade. In comparison, the price impact was 0.91% for diversified traders and 0.85% for value managers. For momentum managers who were unloading stocks in falling markets, the price impact was even higher-2.24%. The cost of trading grew pricier when Keim segregated the trades by degree of difficulty, such as market capitalization and trade size. In the upper ranges of equity trade size, one-way price impacts for momentum adherents reached 3% to 3.5%.

Keim derived the price-impact figures through a mathematical formula that measured the financial impact of institutional trades. The formula is based on the premise that institutional trades are large and, consequently, the trades move security prices. For instance, an institutional trader wanting to buy 50,000 shares of a stock will have to pay a price concession to a market maker to complete the trade. The trader won't be able to buy that many shares at the prevailing ask price. The price impact equation measures this "excess" stock price movement.

"The price impacts here represent a clearer picture of the costs of implementing momentum strategies than previously reported in the literature and set a very high hurdle rate for the profits implied by the simulated strategies," Keim states in his study. "The reality inevitably falls short of the illusion."

While Keim believes that the returns of simulated momentum-based trades can't cover the costs of real-life momentum trading, he says one significant question remains unanswered: Can momentum traders in practice generate returns that exceed actual implementation costs? He acknowledges that the continued proliferation of momentum managers suggests that making money on this strategy is certainly possible.

Clifford S. Asness, a managing principal at AQR Capital Management LLC in New York, which uses momentum trading techniques, says the flaw in the recent research is in assuming that professional momentum traders only embrace that one particular investing style. "We at AQR, and many people who trade momentum, do not trade it alone in a vacuum. We trade it in combination with value strategies."

Asness cites as an example a long-short manager who divides his portfolio into a momentum-based long-short portfolio and a value-based long-short portfolio. Rather than trade them separately, he trades the net of the two positions. He gains two tremendous benefits from this approach. First, before transaction costs are calculated, both momentum and value approaches, enjoy positive historical Sharpe ratios and, even better, are negatively correlated with each other. Thus the two together have a much higher gross Sharpe ratio than either alone.

Second, transaction costs are greatly reduced by trading them together and are far lower than they would be in a pure momentum portfolio. Many securities that are good on momentum (or vice versa), but bad on value are simply never traded.

Consequently, Asness argues, "the after-transactions-costs, risk-adjusted return of value plus momentum is far and away better than momentum alone." He also argues that using both approaches is "far better than just value."

Sheridan Titman, one of the original researchers to document the momentum phenomenon, sides with Asness in defending the research documenting the strategy as profitable. Simulated trading doesn't resemble real-life experiences. "You have to have people who know how to trade," Titman says. "If you blindly buy at the end of the day in the market, as we do in simulated strategies, it won't work out."