Boris Thompson, one of the Lunnar managers, claims to have had consistent success in beating his benchmark by using price momentum as a rewarded equity factor exposure. Popkirk warns her analysts that the manager may not be truly forthcoming regarding some periods of underperformance.
Q. Which of the following is best described as a major drawback of using Thompson’s approach? It is subject to:
A. a value trap.
B. a growth trap.
C. extreme tail risk
Can you explain the difference between value trap and extreme tail risk. Why the answer should be C. extreme tail risk for the above question.
A value trap is basically an attractive looking investment in value terms which is due to eroded fundamentals. The guy above is playing mainly on stock momentum and nothing else.
If a company keeps correcting to a point it might have reached its support, a trader playing on momentum might just keep shorting the stock, ignoring any short covering, exposing him to heavy downside (tail) risk. If this had to be a value trap, he would have bought a really undervalued stock, unaware of its fundamentals.
for the latter explanation, you meant : the trader believes that the stock price would still decrease, therefore she shorts such stock, right? but why does it bring her a tail risk exposure here?
Tail risk is the risk when the price is decrease more than you expected right? But here, if the momentum hold here, when the trader keep shorting the stock, i think it is good, right? it is’nt a risk ?
the reason it would bring her a tail risk exposure is because she’s assuming the momentum might continue when it might actually not. if she were to keep shorting based on just price momentum, she’s ignoring the possibility of shorts being covered on the stock which could be a strong possibility.
yeah. tail risk is downside risk. if momentum persists and she’s a part of it, she’ll probably profit then but the risk still persists by assuming that stock price will continue to drop and she’ll continue to short. never ignore the possibility of change in momentum which could be due to a lot of factors (eg - behavioral, value, etc).