Summing-Up Insights into Momentum Strategies

Related to all momentum based strategies:

Authors: Roncalli

Title: Keep Up the Momentum



The momentum risk premium is one of the most important alternative risk premia alongside the carry risk premium. However, it appears that it is not always well understood. For example, is it an alpha or a beta exposure? Is it a skewness risk premium or a market anomaly? Does it pursue a performance objective or a hedging objective? What are the differences between time-series and cross-section momentum? What are the main drivers of momentum returns? What does it mean when we say that it is a convex and not a concave strategy? Why is the momentum risk premium a diversifying engine, and not an absolute return strategy?

The goal of this paper is to provide specific and relevant answers to all these questions. The answers can already be found in the technical paper "Understanding the Momentum Risk Premium" published recently by Jusselin et al. (2017). However, the underlying mathematics can be daunting to readers. Therefore, this discussion paper presents the key messages and the associated financial insights behind these results.

Among the main findings, one result is of the most importance. To trend is to diversify in bad times. In good times, trend-following strategies offer no significant diversification power. Indeed, they are beta strategies. This is not a problem, since investors do not need to be diversified at all times. In particular, they do not need diversification in good times, because they do not want that the positive returns generated by some assets to be cancelled out by negative returns on other assets. This is why diversification may destroy portfolio performance in good times. Investors only need diversification in bad economic times and stressed markets.

This diversification asymmetry is essential when investing in beta strategies like alternative risk premia. On the contrary, this diversification asymmetry is irrelevant when investing in absolute return strategies. However, we know that generating performance with alpha strategies is much more difficult than generating performance with beta strategies. Therefore, beta is beautiful, but convex beta is precious and scarce. Among risk premia, momentum is one of the few strategies to offer this diversification asymmetry. This is why investing in momentum is a decision of portfolio construction, and not a search for alpha.

Notable quotations from the academic research paper:

"Key Takeaways:

The performance of momentum strategies depends on three main parameters:
   – The absolute value of Sharpe ratios
   – The correlation matrix of asset returns
   – The moving average duration to estimate the trends

Time-series momentum likes zero-correlated assets. This is why time-series momentum makes sense in a multi-asset framework.

Cross-section-momentum likes highly correlated assets. This is why cross-section momentum makes sense within a universe of homogenous assets, e.g. a universe of stocks that belong to the same region.

Short-term momentum is more risky than long-term momentum. Therefore, the cross-section dispersion of short-term momentum returns is broader than the cross-section dispersion of long-term momentum returns.

The Sharpe ratio of long-term momentum is higher than the Sharpe ratio of short-term momentum.

The choice of the moving average estimator is more crucial for short-term momentum than for long-term momentum.

Too much leverage can be harmful for the strategy, since momentum portfolios are not homothetic transformations with respect to the portfolio's leverage.

The payoff of a trend-following strategy is a long straddle option profi le. Therefore, trend-following strategies exhibit a convex payoff .

Trend-following portfolios are not absolute return strategies. In the long-run, trend-following strategies present a low moderate correlation with traditional asset classes. However, it is an illusion due to long-term averaging, since they present either a high positive or a high negative beta.

The main motivation of momentum investing is diversi fication, not performance. The convexity of trend-following strategies mitigates the risk of diversi fied portfolios in bad times. This is why momentum strategies must be located in diversifying buckets, and not in absolute return buckets. Therefore, analysing the risk/return trade-off of momentum strategies on a standalone basis does not make sense.

It follows that momentum risk premium is key for building an alternative risk premia portfolio.


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