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Momentum Has Its Moments

Last Updated on 10 February, 2024 by Rejaul Karim

In the paper “Momentum Has Its Moments” by Pedro Barroso and Pedro Santa-Clara, the focus lies on the momentum strategy of investing, which is known for providing the highest Sharpe ratio in comparison to market, value, or size factors.

However, the strategy also has a downside, as it has encountered the most extreme crashes, thus becoming less attractive to investors who are averse to negative skewness and kurtosis. The research reveals that the risk associated with momentum is not only highly variable over time but also predictable.

By managing this risk, crashes can be nearly eliminated, resulting in an almost doubled Sharpe ratio for the momentum strategy. This risk-managed momentum presents a more significant challenge than its unmanaged counterpart, sparking further curiosity in the field of investment strategies.

Abstract Of Paper

Compared with the market, value, or size factors, momentum has offered investors the highest Sharpe ratio. However, momentum has also had the worst crashes, making the strategy unappealing to investors who dislike negative skewness and kurtosis. We find that the risk of momentum is highly variable over time and predictable. Managing this risk virtually eliminates crashes and nearly doubles the Sharpe ratio of the momentum strategy. Risk-managed momentum is a much greater puzzle than the original version.

Original paper – Download PDF

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Author

Pedro Barroso
CATÓLICA-LISBON School of Business & Economics

Pedro Santa-Clara
Nova School of Business and Economics; National Bureau of Economic Research (NBER); Centre for Economic Policy Research (CEPR)

Conclusion

In conclusion, the paper “Momentum Has Its Moments” by Pedro Barroso and Pedro Santa-Clara provides valuable insights into momentum investment strategies and their associated risks. While momentum has historically offered the highest Sharpe ratio compared to market, value, or size factors, it has also been plagued by the worst crashes, making it less attractive to risk-averse investors.

However, the research uncovers that the risk associated with momentum is not only variable over time but also predictable. By effectively managing this risk, significant crashes can be virtually eliminated, and the strategy’s Sharpe ratio can be almost doubled.

The concept of risk-managed momentum thus presents a more significant challenge and opens up new perspectives for further investigation in the realm of investment strategies and risk management.

Related Reading:

Momentum, Risk, and Underreaction

The Role of Shorting, Firm Size, and Time on Market Anomalies

FAQ

Q1: What distinguishes the momentum strategy in terms of risk and return, and why might it be unappealing to some investors?

The momentum strategy stands out for providing the highest Sharpe ratio compared to market, value, or size factors. However, it has also experienced the most extreme crashes, introducing negative skewness and kurtosis. This aspect makes it less appealing to investors averse to such negative characteristics.

Q2: How does the research contribute to understanding the risk associated with momentum, and what is the key insight regarding risk predictability?

The research reveals that the risk of momentum is highly variable over time and, importantly, predictable. Understanding the predictability of risk in the momentum strategy is a key insight, as it enables effective risk management strategies.

Q3: How can managing the risk associated with momentum impact its performance, and what does the research suggest about risk-managed momentum?

Effectively managing the risk associated with momentum can virtually eliminate significant crashes, resulting in an almost doubled Sharpe ratio for the strategy. The research introduces the concept of risk-managed momentum, which presents a more significant challenge than the original strategy and raises intriguing questions about the dynamics of momentum and risk management.

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