Upside and Downside Risks in Momentum Returns

A new related paper has been added to:

#13 – Short Term Reversal in Stocks
#14 – Momentum Effect in Stocks

#15 – Momentum Effect in Country Equity Indexes

Authors: Dobrynskaya

Title: Upside and Downside Risks in Momentum Returns



I provide a novel risk-based explanation for the profitability of momentum strategies. I show that the past winners and the past losers are differently exposed to the upside and downside market risks. Winners systematically have higher relative downside market betas and lower relative upside market betas than losers. As a result, the winner-minus-loser momentum portfolios are exposed to extra downside market risk, but hedge against the upside market risk. Such asymmetry in the upside and downside risks is a mechanical consequence of rebalancing momentum portfolios. But it is unattractive for an investor because both positive relative downside betas and negative relative upside betas carry positive risk premiums according to the Downside-Risk CAPM. Hence, the high returns to momentum strategies are a mere compensation for their upside and downside risks. The Downside Risk-CAPM is a robust unifying explanation of returns to momentum portfolios, constructed for different geographical and asset markets, and it outperforms alternative multi-factor models.

Notable quotations from the academic research paper:

"I show that the downside risk alone does not fully explain the returns to the cross-section of momentum portfolios because the upside risk plays a significant role too and cannot be neglected. In fact, it is the difference in the downside and upside betas (beta asymmetry) which varies across momentum portfolios the greatest. For any cross-section of momentum portfolios considered, the difference in betas is monotonically increasing from past losers to past winners. As a result, the winner-minus-loser momentum portfolios are exposed to the downside risk, but hedge against the upside risk.

This finding is consistent with a recent study by Daniel and Moskowitz (2014), who show that the winner-minus-loser momentum portfolios tend to crash when the market rebounds after a decline. The momentum crashes occur during the market upturns because these portfolios appear to be long in the low-beta stocks and short in the high-beta stocks picked in the preceding formation period of the declining market. But if the formation period coincides with the growing market, on the contrary, the momentum portfolios appears to be long in the high-beta stocks and short in the low-beta stocks, what leads to their high exposure to the downside risk if the market turns down. Because the momentum portfolios are rebalanced periodically, and because the market changes its trend often, the momentum portfolios appear to have positive downside betas and negative upside betas mechanically. Recent studies by Barroso and Santa-Clara (2015) and Jacobs, Regele and Weber (2015) also show that past winner and loser portfolios have asymmetric return distributions and, as a result, the momentum portfolio returns exhibit significant negative skewness and high kurtosis. Such asymmetry in risks is not attractive for an investor and requires a risk premium.

In the cross-sectional tests, I show that the relative downside beta, which captures the extra downside risk and, hence, the downside-upside risk asymmetry, explains the returns to the momentum portfolios well, whereas the traditional beta has no explanatory power. The relative downside beta premium is approximately 3-4 percent per month, highly statistically significant and similar in magnitude to the estimates obtained for the stock and currency markets (Lettau et al., 2014; Dobrynskaya, 2014).

My findings are similar for all cross-sections of momentum portfolios in different geographical markets and asset classes. I study the US, Global, European, North-American and Asian-Pacific momentum portfolios of individual stocks, global momentum portfolios of country indices, currency momentum portfolios. I show that momentum is a global phenomenon indeed, and its upside-downside risk structure is similar around the world and in different asset markets. I confirm the findings of Asness, Moskowitz, and Pedersen (2013) that momentum strategies in different locations and asset markets share common risks. But the major contribution of this paper is to show that a microfounded theoretical asset-pricing model (namely, the Downside-Risk CAPM – DR-CAPM) previously used to explain stock and currency returns can also explain the momentum returns well."

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