Swedroe: Risk-Managed Momentum Outperforms

May 27, 2015

Momentum has been found to be a persistent and pervasive factor in the returns not only of stocks, but of other asset classes (including bonds, commodities and currencies). Compared with the market, value and size risk factors, momentum in equities has earned both the highest premium and the highest Sharpe ratio.


However, momentum has also experienced the worst crashes, making the strategy unappealing to investors with a strong risk aversion.


Pedro Barroso and Pedro Santa-Clara—authors of the study “Momentum Has Its Moments,” which appears in the April 2015 issue of the Journal of Financial Economics —found that the risks associated with momentum are highly variable over time and are quite predictable.


They determined that the major source of predictability doesn’t originate from a systematic risk. Instead, it’s a specific, time-varying risk. Furthermore, they discovered management of the risk virtually eliminates crashes and nearly doubles the Sharpe ratio (a measure of risk-adjusted returns) of the momentum strategy. And that only serves to make what the authors termed “risk-managed momentum” an even greater puzzle than the original version.


The Dark Side Of Momentum
Barroso and Santa-Clara, whose study covered the period from 1927 through 2011, found that buying winners and shorting losers has provided large returns (14.5 percent per year), with a Sharpe ratio higher than the market. This impressive excess return to momentum, its high Sharpe ratio and negative relation to other risk factors (particularly the value premium) can make the strategy appear to be a free lunch for investors. But as we mentioned earlier, there’s a dark side to momentum.


In 1932, the winners-minus-losers strategy delivered a -91.6 percent return in just two months. In 2009, momentum experienced a crash of -73.4 percent in just three months. These are the types of losses that can take decades for investors to recover from.


That said, momentum crashes result from the strategy’s short side, and they occur during reversals (such as we experienced in March 2009) after periods of sharp decline. Thus, investors using long-only momentum strategies don’t have to worry about crashes. Long-short momentum strategies, however, are exposed to crashes.


The bottom line is that the benefits of employing momentum come with risks. In particular, a high excess kurtosis (fat tail) of 18.2 combined with a pronounced left skew (where values to the left of, or less than, the mean are fewer but farther from it than the values to the right of, or greater than, the mean) of -2.5.


Trimming The Fat (Tail)
These two features of the momentum strategy mean that it carries the risk of large losses. But it’s important to not think of an asset in isolation. Instead, think about how the asset’s addition impacts the portfolio’s return as a whole. With that in mind, the study’s authors provide an important insight that investors could use to minimize fat-tail risk in momentum strategies.


Barroso and Santa-Clara concluded that momentum risk isn’t constant; rather, as we mentioned earlier, that it varies over time. The authors found if they scaled exposure to momentum (using the realized variance of daily returns over 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 their most significant lows in the early 1930s, in 2000 through 2002 and in 2008 through 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 go on to add: “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. Also, the risk-managed strategy no longer has variable and persistent risk, so risk management indeed works.”



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