Swedroe: Finer Points Of Momentum Factor
Targeting volatility can make leveraging the momentum factor more palatable.
Targeting volatility can make leveraging the momentum factor more palatable.
Targeting volatility can make leveraging the momentum factor more palatable.
Compared with risk factors in investing—such as the market, value or size—momentum has offered investors the highest Sharpe ratio.
However, momentum does have a dark side, as it has had some of the worst crashes.
The large gains associated with the momentum factor come at the expense of a very high excess kurtosis (fat tail) of 18.2, as well as a pronounced left-skew of -2.5, which is to say that values that are less than the mean are fewer but farther from the mean than values that are greater than the mean.
These two features of the momentum strategy mean there is the risk of a large loss. Said another way, the apparent “free lunch” of momentum returns can very rapidly turn into a free fall, wiping out decades of returns. This feature makes the strategy unappealing to investors with strong risk aversion.
That said, it’s important to note that momentum crashes result from the short side, occurring during reversals such as we experienced in March 2009. Thus, investors using long-only momentum strategies don’t have to worry about crashes. However, long-short momentum strategies are exposed to crashes.
The authors of the 2012 study “Managing the Risk of Momentum,” found that the risk of momentum is highly variable over time and is quite predictable. They found that the major source of predictability doesn’t come from a systematic risk. Instead, it’s a specific, time-varying risk. And while returns are difficult to forecast, volatility is less difficult to predict.
The reason is that this month’s volatility provides information about next month’s volatility. That makes volatility a useful risk-management input that can greatly reduce the impact of crashes in long/short momentum strategies.
The way to mitigate the risk of crashes is to vary the exposure to momentum over time. The authors found that if they scaled exposure to momentum by using the realized variance of the daily returns in the previous six months, the risk-managed momentum strategy achieves a higher cumulative return with less risk. The weights of the scaled momentum strategy over time ranged between the values of 0.13 and 2.00, reaching the most significant lows in the early 1930s, in 2000-2002, and in 2008-2009.
On average, the weight was 0.90, slightly less than full exposure to momentum. The authors concluded: “As these weights depend only on ex-ante information this strategy could actually be implemented in real time.” They added: “The scaled strategy benefits from the large momentum returns when it performs well and effectively shuts it off in turbulent times, thus mitigating momentum crashes (the largest drawdowns are smaller). Also, the risk-managed strategy no longer has variable and persistent risk, so risk management indeed works.”
By targeting a specific level of volatility, a long/short momentum strategy would invest fewer dollars when markets are more volatile and more dollars when markets are less volatile. This is the approach AQR uses in its Style Premium Alternative Fund (QSPIX).
Volatility-targeting requires two inputs: a volatility target; and a volatility forecast. The target is the desired level of risk, and the forecast is based on market risk. Dividing the target by the forecast, you calculate the allocation needed to reach the desired level of risk. For example, if the target level of volatility is 10 percent, and the forecast is 20 percent, the fund would invest only half its assets. Such an approach has historically dampened volatility without negatively impacting returns.
While many investors believe that highly volatile markets occur as a result of large losses—in which case volatility targeting would sell after a drop in prices has already occurred)—AQR’s research has found that, empirically, this isn’t the case. In fact, AQR’s research found that the contrary holds more often than not, as increased volatility generally precedes large drawdowns.
In a study of more than 70 liquid investments in several asset classes between 2000 and 2011, AQR analyzed how constant volatility targeting (using rolling 21-day volatilities) changed risk and performance statistics compared with constant nominal holdings. A measure of “fat-tailedness,” kurtosis, declined in about 80 percent of the cases. In addition, the Sharpe ratios increased in about 70 percent of the cases, with the average across all assets rising from 0.32 to 0.40.
Also, by reducing the risk of large losses, volatility targeting can also provide the benefit of increasing investor discipline—reducing the risk of stressed investors abandoning their plans and engaging in panic selling.
Larry Swedroe is a director of Research for the BAM Alliance, a community of more than 130 independent registered investment advisors throughout the country.
