Price momentum: the trend is your friend, until it isn’t

During periods when the market travels in one direction, momentum strategies – which we introduced in our previous blog – have tended to outperform, giving rise to the saying ‘the trend is your friend’.

Occasionally, however, the strategy suffers from performance drawdowns, also known as ‘crash risk’. This occurs when the price has risen too far beyond underlying fundamentals and is forced to reverse, or when market sentiment shifts suddenly, triggering a sell-off.

To illustrate this dynamic, imagine you have been invited to attend a party. Initially, there are only a few guests, but as the evening progresses, more people gradually arrive and everyone starts to enjoy themselves. As midnight approaches, the party hits critical mass and begins to feel crowded. Suddenly, the neighbours complain, the police turn up and everybody is forced to leave.

Much like the party, momentum strategies can often suffer from overcrowding to the point where a minor catalyst is enough to trigger a significant reversal.

Incorporating risk mitigation

While trying to time the market comes with obvious risks, there are methods that can serve as early warning signs for changes in market direction or, in our analogy, hint that your neighbour might be about to call the police.

One common approach is incorporating a one-month reversal into a 12-month momentum strategy, where the most recent month of a 12-month period is excluded to account for potential reversals, when investors are likely to take profit after an extended period of gains.

Another enhancement to the standard (12-1) month momentum strategy involves further adjusting for the security’s volatility. Scaling by volatility introduces a risk-mitigation component to the strategy.¹ Momentum strategies are particularly vulnerable during inflection points when markets may rebound from the lows (known as a ‘trash rally’) or correct from the highs (crash risk) without maintaining the trend. These fluctuations are often accompanied by a surge in volatility that can persist.

By incorporating a volatility adjustment, we can systematically aim to reduce exposure to highly volatile securities as they enter turbulent periods, thereby potentially reducing the severity of drawdowns.

How well can it work?

To test the effectiveness of this approach, we constructed a risk-adjusted (12-1)-month momentum strategy by applying the same score tilt method as before, but with the momentum signals now scaled by the stock’s volatility. The scores were generated using our proprietary L&G Multi-Factor Scoring Framework.

The graph below illustrates the historical drawdowns of the L&G Risk-Adjusted Momentum and the L&G Standard Momentum strategies over a 23-year period. Our analysis shows that by simply scaling the score-based signals for volatility, it is possible to reduce the sharpness of the drawdowns, especially over-stressed market scenarios, as highlighted in grey.

Likewise, the benefits of risk scaling are apparent when comparing the performance of the risk-adjusted momentum strategy with its standard counterpart over challenging market conditions. Out of 25 quarterly periods with negative returns for the standard momentum strategy, the risk-adjusted equivalent outperformed in 21 instances, achieving a notable hit rate of 84%. Note that this analysis was done on historical data, which of course means it isn’t guaranteed to repeat in the future.

Furthermore, the performance of the risk-adjusted momentum strategy is also higher than the standard momentum strategy over the period in question.

So far, we have demonstrated the benefits of risk adjustment within a long-only context. While the intention here is not to develop an ‘all-weather’ strategy, the refined approach does offer a viable enhancement to address one of the main shortcomings of the standard momentum strategy.

Our research has shown that the momentum factor remains a significant force in investment, achieving notable performance. Despite its challenges, particularly during volatile market conditions, adjustments can be made to improve its effectiveness. By mitigating the reversal effect and incorporating a volatility or risk adjustment, investors can seek to harness the benefits of the momentum factor while attempting to dampen its inherently riskier features. Adjusting for volatility is one viable option to refine the standard momentum strategy.

However, other methods, such as considering short interest or comparing a stock’s price to its 52-week high, could provide additional avenues for improvement and warrant further research in the future.

1. Source: Barroso, P. and Santa-Clara, P. (2014). Momentum Has Its Moments. Available at: https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2041429