Enhancing momentum with volatility and risk management : an empirical analysis of momentum in US equities

Abstract

In this thesis, we examine two approaches to enhance the performance of a momentum strategy. First, we investigate if stocks with similar cumulative returns but different daily standard deviation during the formation period perform differently in the holding period. We find a large variation in the performance of portfolios within each decile formed on cumulative returns, where the most volatile portfolio clearly underperforms. We construct a volatility dependent momentum strategy, that excludes the most volatile winners and losers. We find that our volatility dependent momentum strategy outperforms a generic momentum strategy, with an annualized Sharpe ratio of 0.43 versus 0.35. Similar to other momentum strategies, we find that our volatility dependent momentum strategy inherits the risk of large drawdowns in periods when the market rebounds after a major decline. In order to reduce the impact of momentum crashes, we introduce a new risk management approach. We exit our volatility dependent momentum strategy when the 12-month cumulative return of the market is negative. Risk management further enhances the Sharpe ratio from 0.43 to 0.81. We find that the combination of taking volatility and risk management into account generates a monthly alpha of 0.62% after controlling for Fama/French 5 Factors including momentum.