Upside and Downside Risks in Momentum Returns

Abstract

I provide a novel risk-based explanation for the profitability of momentum strategies. I show that the past winners and the past losers are differently exposed to the upside and downside market risks. Winners systematically have higher relative downside market betas and lower relative upside market betas than losers. As a result, the winner-minus-loser momentum portfolios are exposed to extra downside market risk, but hedge against the upside market risk. Such asymmetry in the upside and downside risks is a mechanical consequence of rebalancing momentum portfolios. But it is unattractive for an investor because both positive relative downside betas and negative relative upside betas carry positive risk premiums according to the Downside-Risk CAPM. Hence, the high returns to momentum strategies are a mere compensation for their upside and downside risks. The Downside Risk-CAPM is a robust unifying explanation of returns to momentum portfolios, constructed for different geographical and asset markets, and it outperforms alternative multi-factor models.

Keywords: momentum, downside risk, downside beta, upside risk, upside beta, Downside-Risk CAPM

JEL Classification: G12, G14, G15