Is it possible to control for momentum's huge crashes?

: scaled residual momentum : a modified approach to momentum investing

Abstract

Many researchers find that information travels slowly and an apparently under-reaction to news. As a response, several relative strength strategies appear. Total momentum is one of the most known and widely used nowadays. However, total momentum has huge crashes from times to times. The early 1930s and the
late 2000s were the two darkest periods for the strategy. In fact, an investor entering in the beginning of these two periods would see 60% to 75% of his investment wiped out. Trying to control for these crashes we study 3 alternative strategies: residual momentum, scaled momentum and scaled residual momentum.
The last strategy scales its exposure to residual momentum, relying on the risk predictability of residual momentum. Our main findings state that overall scaled residual momentum has a Sharpe ratio slightly lower than scaled momentum (0,91 vs 1,00), but in turbulent times this reverts completely. In the early 1930s and
the late 2000s it becomes the strategy with highest Sharpe ratio (ranging from 0,36 to 0,66) and highest cumulative return. For the same periods, where total momentum has huge losses, an investor would see a valorization of 20% (in the late 2000s) and of 60% (in the early 1930s). The reason for this is the evident
superiority shown by scaled residual momentum in terms of controlling for the crashes - lowest kurtosis, less negative skewness and lower and shorter drawdowns.

Date of Award	9 May 2017
Original language	English
Awarding Institution	Universidade Católica Portuguesa
Supervisor	Joni Kokkonen (Supervisor)