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Momentum trading and setback risk

An empirical study suggests that momentum trades yield positive returns but carry higher downside than upside market risk. This “beta asymmetry” appears to be a global phenomenon across asset classes.  It is consistent with the broader observation that popular trading strategies come at the price of setback risk related to the crowdedness of positions.

Dobrynskaya, Victoria (2015), “Upside and Downside Risks in Momentum Returns”, National Research University, Higher School of Economics Moscow,  Basic Research Program, Working papers, 50/FE/2015

The below are excerpts from the paper. Headings, links and cursive text have been added.

Momentum strategies

“The momentum anomaly has received a lot of attention. Buying past winners and selling past losers generates abnormal returns in the short run, which cannot be explained by conventional risk measures(e.g. the standard deviation and the market beta) and provide evidence for market inefficiency. Momentum strategies proved to be profitable around the world [according to various academic research papers], at the level of national equity indices, at the individual stock level, among currencies, commodities, bonds and other assets.”

“Momentum portfolios in different geographical regions and asset classes are correlated and, perhaps, share a common component.”

For empirical evidence on the performance of strategies based on momentum and trend following (directional momentum) in the global equity and FX markets also view post here.

On the origin of financial market trends view post here.

Why momentum strategies make money

Asymmetry in upside and downside market risks explains the returns to the cross-section of global momentum portfolios well…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 the downside market risk, but hedge against the upside market risk… After controlling for the market risk, the relative downside beta carries a positive risk premium and the relative upside beta carries a negative risk premium…Greater relative downside risk and lower relative upside risk of past winners are compensated by higher returns.”


“The relative downside beta measures additional market risk on the downside, after controlling for the overall market risk measured by the regular market beta. A portfolio may have lower market beta, but greater exposure to the downside risk, and hence may require higher returns, because investors care more about performance in down states. This can only be seen after separating the overall market risk and the downside market risk.”

“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…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.”

“Findings are similar for all cross-sections of momentum portfolios in different geographical markets and asset classes [over varying sample periods from 15 to 90 years]. 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 and…momentum portfolios in different asset classes…Momentum is a global phenomenon indeed, and its upside-downside risk structure is similar around the world and in different asset markets.”

“The Capital Asset Pricing Model (CAPM) with the downside risk has greater explanatory power in the stock, currency, commodity and bond markets than the regular CAPM…The exposure to the downside risk is a unifying explanation for returns in different asset markets.”



Other corroborating evidence

“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…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.”

“Ang et al. (2006) show how…in a theoretical model with disappointment aversion… the traditional CAPM alpha is increasing in the relative downside beta, decreasing in the relative upside beta and, hence, increasing with the difference between the downside and upside betas (downside-upside beta asymmetry).”


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