Sunday, April 22, 2012

Paper: "Managing the Risk of Momentum"

As you know, I think that momentum investing is totally idiotic. Reading a paper called "Managing the Risk of Momentum," which acknowledges the fatal flaw of the method but purports to be able to avoid the big drawdowns.

"[T]he remarkable performance of momentum comes with occasional large crashes. In 1932, the winners-minus-losers strategy delivered a -91.59 percent return in just two months. In 2009 momentum experienced another signi…ficant crash of -73.42 percent over three months. Even the large returns of momentum do not compensate an investor with reasonable risk version for these sudden crashes that take decades to recover from."
These guys use "the realized variance in the previous 6 months to scale the exposure to momentum." In other words, they think that they can predict crashes. However, the "auto-regression of monthly realized variances yields an out-of-sample (OOS) R-square of 57.82 percent."

I've written about this before - momentum investing doesn't really make economic sense. It's especially funny when the jokers running the momentum funds don't talk about full cycle returns.