Momentum, minus the risk

Introduction

Momentum investing is a widely popular and well researched investment style among both academics and market practitioners. It has consistently delivered solid performance across a variety of asset classes, market regimes, regions, and time periods.¹ However, momentum strategies often carry higher volatility. Momentum works well, but when trends reverse, risks increase. In this article, we’ll break down what momentum is, how it works, and how you can mitigate its risks. A possible solution could be dynamic hedging, which seeks to minimize drawdowns.

Momentum – why does it matter?

Momentum refers to the idea that past returns positively correlate with future returns. This is not too dissimilar to weather patterns. If it rained yesterday and today, most likely it will rain tomorrow too.² For investable assets, this boils down to saying that if an asset has gone up recently, it is more likely that it will continue to go up. The same holds true in reverse, by the way. This is the core of momentum investing: betting on the continuation of existing trends.

The idea is not new. In fact, a group of commodity traders, armed with the first personal computers in the 80s, were considered the first to systematically exploit the opportunity to their advantages.³ And while one would think that over time, as knowledge spreads, the opportunity would vanish, it has actually persisted, to the point that momentum has become a well-known, academically proven investment factor. This investment strategy is a fundamental approach, academically confirmed, that investors use to explain and capture stock market returns.

How do we exploit momentum? 

It is quite simple, in theory, to harness momentum. Consider a universe of stocks and rank them based on their recent performance. The top-performing stocks, those showing the strongest upward trends, are selected for the portfolio. By focusing on those, the goal is to capture their potential continued rise.

Momentum investing has shown surprising strength. Research by Cliff Asness, Tobias Moskowitz, and Lasse Pedersen in their paper “Value and Momentum Everywhere”⁴ demonstrated that the top tercile of stocks ranked by momentum consistently outperforms the bottom tercile, and that by at least 5 percentage points annually. This isn’t limited to specific regions or periods—it holds true globally and across different market conditions.

The momentum effect also persists across economic cycles. Whether the economy is slowing down, contracting, recovering, or expanding, momentum portfolios have historically outperformed other styles, particularly during slowdowns and recoveries.⁵

What are the pitfalls with momentum?

While momentum strategies can deliver strong returns, they come with a significant downside—high volatility. When trends reverse, momentum stocks can experience sharp drawdowns, which translates into increased risk for portfolios. As a result, momentum portfolios can suffer during periods of market stress, making them more volatile than other investment styles.

Momentum strategies can experience the highest volatility across all economic cycles, reinforcing the need for active risk management. Interestingly, the lack of significant differences in volatility across cycles suggests that momentum strategies remain risky regardless of economic conditions. This finding underlines the importance of a dynamic hedging approach that can adapt to rising volatility in any phase of the economic cycle.

How can we play momentum wisely?

The key to improving momentum strategies lies in managing the risk, especially during (or ideally ahead of) turbulent market conditions. Our strategy involves dynamic hedging: when market volatility rises, we implement a short position⁶ in the broader market to protect the portfolio. Based on our research, sudden increases in market volatility are a solid predictor of turbulence ahead.

A study by our team of experts compares long-only momentum (LO) and long hedge (LH) strategies in the US, Europe and Switzerland and suggests that dynamic hedging can have a positive impact on returns and volatility.

In the U.S., dynamic hedging increases excess returns from 8.6 percent to 9.2 percent, with a 4.7 percentage point reduction in volatility. This boosts the Sharpe Ratio⁷ from 0.4 to 0.6, making the U.S. the region with the best overall risk-adjusted return improvement.

In Europe, volatility drops by 5.1 percentage points—the largest reduction across regions—while excess returns rise slightly by 0.2 percentage points, improving the Sharpe Ratio to 0.3.

For Switzerland, the strategy reduces volatility by 2.5 percentage points and increases returns by 0.3 percentage points, resulting in a higher Sharpe Ratio of 0.5.

While all regions benefit, the U.S. shows the best balance between increased returns and reduced volatility, whereas Europe experiences the most volatility reduction.⁸

Conclusion

Momentum investing provides an opportunity to capitalize on market trends, but it carries risks. Specifically, it is a style prone to sudden and sharp drawdowns. Dynamic hedging provides a solution by protecting portfolios during periods of market stress, allowing investors to benefit from momentum while controlling some of the adverse risks. For those looking to optimize returns and minimize volatility, momentum trackers with hedging strategies offer a smarter, more resilient approach.

¹ Source: Asness, Cliff S. and Moskowitz, Tobias J. and Moskowitz, Tobias J. and Pedersen, Lasse Heje, Value and Momentum Everywhere (June 1, 2012). Chicago Booth Research Paper No. 12-53, Fama-Miller Working Paper, Available at SSRN:https://ssrn.com/abstract=2174501or http://dx.doi.org/10.2139/ssrn.2174501

² Source: For a comprehensive review of the persistence of weather patterns (and an analysis of how it’s increased due to climate change), please consult  https://doi.org/10.1175/BAMS-D-21-0140.1.

Dr. Haibo Du and Dr. Markus Donat, “Extreme Precipitation on Consecutive Days Occurs More Often in a Warming Climate” (April 2022), American Meteorological Society

(Please spell the whole correct reference, with authors, full title, and journal).

³ Source: For an inspiring recount of the events, consult Michael W. Covel, “The Complete TurtleTrader”

⁴ Source: Asness, Cliff S. and Moskowitz, Tobias J. and Moskowitz, Tobias J. and Pedersen, Lasse Heje, Value and Momentum Everywhere (June 1, 2012). Chicago Booth Research Paper No. 12-53, Fama-Miller Working Paper, Available at SSRN:https://ssrn.com/abstract=2174501or http://dx.doi.org/10.2139/ssrn.2174501

⁵ "Shorting" is a strategy where you borrow and sell securities, expecting their price to drop. If it does, you buy them back at a lower price and profit from the difference. However, if the price rises, you face potential losses. Essentially, it's betting on a price drop, which can either yield profit or result in losses.

⁶ The Sharpe Ratio is a financial metric that quantifies the additional return an investment yields over a risk-free asset for each unit of risk undertaken. It is computed by subtracting the risk-free return from the investment return, and then dividing the result by the standard deviation of the investment returns. A higher Sharpe Ratio indicates a more efficient risk-reward trade-off, signifying that the investor is receiving a greater return for each unit of risk assumed

⁷ Source: Vontobel