Profiting from momentum strategies - Part 1

Momentum is arguably the most well-known trading strategy. A simple strategy of buying stocks that have done well over the past 6 months ("winners"), and shorting stocks that have done badly ("losers"), earns a 1%/month return over the next 6 months. While other trading strategies stop being profitable once they have been discovered (because investors start exploiting them, removing the profit opportunity), momentum has remained surprisingly lucrative ever since Jegadeesh and Titman (1993) first documented it. 

A momentum strategy is attractive because it is market-neutral - since you're buying some shares and shorting others, it can make money in up markets and down markets. Thus, it is relatively immune to market risk. The Sharpe Ratio (a measure of the risk-adjusted return to a trading strategy) of momentum is about 0.6, compared to 0.3-0.4 for just holding the market. I attempt to exploit momentum myself, through the AQR Momentum ETF (ticker AMOMX).

Momentum is also pervasive - it works not only in stocks, but also bonds, commodities and exchange rates as shown by Asness, Moskowitz, and Pedersen (2013). That we see it in so many assets suggests that momentum is due to investors making mistakes - popularized by a branch of research known as "behavioral finance". The main psychological explanation is that investors are slow to react to information - thus, good news takes time to be incorporated in prices, and ditto for bad news. 

However, even though the momentum strategy does well on average, there are some periods where it does very badly, such as in the recent hedge fund crisis - some hedge funds went under because they followed momentum strategies that tanked. For example, between March and May 2009, the "losers" generated 163% returns, but the "winners" generated only 8% returns. Thus, a momentum strategy is somewhat like selling options - it makes money on average, but sometimes does really badly.

This new paper by Kent Daniel of Columbia GSB, a former Managing Director in Sachs Asset Management and Toby Moskowitz of Chicago Booth, a former winner of the Fischer Black Prize for outstanding contributions to finance research by someone under 40, shows you when to get out of momentum strategies - and thus how to make momentum even more profitable. 

The answer is surprisingly simple - get out of the momentum strategy in times of market stress, when 1) the market has recently declined, and 2) market volatility (measured by the VIX volatility index) is high. Here's a simple intuition. If the market has recently declined, the "loser" portfolio must have declined much faster than the broader market. Thus, it has a high beta (= sensitivity to the market). The "winner" portfolio has a relatively low beta, which is why it didn't decline so much. After times of market stress, the market typically recovers. Thus, the "loser" portfolio, which has high beta stocks that are sensitive to the market, does especially well in the market recovery, and so you want to get out of the momentum strategy. Kent and Toby find that this surprisingly simple enhancement to the momentum strategy doubles the Sharpe ratio from 0.6 to 1.2.