Timing, Momentum and Beyond
For many finance is all regarding predicting returns. sadly, securities market returns square measure (almost) unpredictable and this cautions against following the elusive gains of market temporal arrangement.
On the opposite hand, commonplace finance theory suggests that investors ought to care regarding risk-adjusted returns — captured (for example) by the Sharpe magnitude relation — as critical mere returns. the nice news for active managers is that this variable already has fascinating certainty. And alternative long-short equity investment factors, reminiscent of momentum, have Sharpe ratios that square measure, astonishingly, even easier to forecast.
Remember that the Sharpe magnitude relation is predicted come back divided by volatility. Active managers usually specialise in attempting to predict the dividend of this magnitude relation. this can be exciting and amusing however is additionally presumably a appealingness. The divisor, volatility, is that the dispense with necessarycertainty.
The chemist Prize-winning work of parliamentarian Engle and full general husbandman, among others, established that risk varies over time within the economy and in money markets. Nowadays, the proof for time-varying volatility is thus compelling that we will be a lot of assured oral communication risk varies over time within thesecurities market than stating there’s associate degree equity premium within the 1st place! (And don’t get American state wrong, the existence of associate degree equity premium is backed by pretty sturdy proof, too.)
Furthermore, as Engle aforesaid, the implications of this time-varying volatility square measure in all probability “not totally absorbed in money follow however.” educational analysis in finance has in all probability not totally incorporated these implications either.
Time-varying volatility not to mention nearly unpredictable returns (namely mistreatment volatility as a predictor) implies that the magnitude relation between the 2variables — the Sharpe magnitude relation — should have some certainty on balance. this easy observation drives associate degree examination of the quality of volatility to time investments in factors. My analysis 1st centered on this by staring at an element nevertheless the market: momentum.
Momentum: Puzzles inside a Puzzle
Momentum could be a well-liked investment strategy that involves shopping for assets that have performed well within the recent past (winners) and shorting those with recent unhealthy returns (losers). This strategy has delivered positive returns during a long sample people stock knowledge from the Nineteen Twenties till nowadays. shopping for stocks playing well within the previous twelve months and merchandising people who performed badly within the same amount has monthly returns of roughly 1 Chronicles that don’t seem to be explained by well-known risk factors. Similar proof has been found for many international equity markets, for historical samples reminiscent of Victorian England and Imperial Russia, and for alternative quality categories also. The generality of momentum not to mention its intriguing nature — why ought to securities market returns continue the short term at all? — build it a central anomaly in money markets.
Despite its profit, momentum conjointly features a dangerous dark facet with appreciable tail risk. On rare occasions, momentum has made intense crashes that were even a lot of pronounced than those of the securities market. as an instance, the strategy suffered a come back of -91.59% in 1932 and -73.42% in 2009. In each cases, the losses occurred in exactly many consecutive months.
My paper “Momentum Has Its Moments,” written with Pedro Santa-Clara, chair in finance at star SbE, studied the time-varying volatility of momentum and its quality in managing exposure to momentum and its crashes. we discover the volatility of the strategy varies well over time during a foreseeable manner. The (annualized) realisedvolatility of momentum varies between three and 128% — a far stronger time-variation than that of the securities market. moreover, quite half this time-varying risk is foreseeable in real time. this can be regarding double the certainty of securities market risk within the last fifty years.
And there’s another puzzle on high of this proof. to supply context, there’s associate degree in progress arguing on the risk-return trade-off of the securities market — that’s, whether or not higher volatility conjointly forecasts higher returns. whereas that relation is debatable for the securities market, the relation for momentum is wayclearer, however conjointly a lot of unsettling: Higher volatility within the strategy, besides foretelling higher volatility going forward, conjointly forecasts lower returns.
As a result, the Sharpe magnitude relation of finance in momentum is very foreseeable. once safe months within the strategy, the Sharpe magnitude relation is regardingone.7, whereas it’s solely zero.28 once risky months. A naive changed momentum strategy mistreatment this certainty has nearly double the Sharpe magnitude relation of normal momentum with abundant less crash risk. this can be a far deeper puzzle than original momentum.
Implications for Active Management
In our in progress work, Paulo F. Maio and that i extend the study of risk-return trade-offs to alternative well-known equity factors. One fascinating result’s that the “betting-against-beta” (BAB) strategy has risk management advantages like those of momentum.
So, these ways that square measure already puzzles in their claim — momentum and BAB — even have intriguing risk management advantages. In fact, they each tend to perform worse once high levels of risk.
These findings don’t explain the existence of anomalies within the 1st place. Rather, they improve our understanding of necessary aspects of their behavior. They even haveprobably fascinating implications for active managers. In general, they appear to substantiate Engle’s read that money follow has however to totally absorb the teachingsof time-varying volatility. above all, active managers square measure wise to pay shut attention to the divisor in their Sharpe ratios.