Keep Up the Momentum

Abstract

The momentum risk premium is one of the most important alternative risk premia alongside the carry risk premium. However, it appears that it is not always well understood. For example, is it an alpha or a beta exposure? Is it a skewness risk premium or a market anomaly? Does it pursue a performance objective or a hedging objective? What are the differences between time-series and cross-section momentum? What are the main drivers of momentum returns? What does it mean when we say that it is a convex and not a concave strategy? Why is the momentum risk premium a diversifying engine, and not an absolute return strategy?

The goal of this paper is to provide specific and relevant answers to all these questions. The answers can already be found in the technical paper "Understanding the Momentum Risk Premium" published recently by Jusselin et al. (2017). However, the underlying mathematics can be daunting to readers. Therefore, this discussion paper presents the key messages and the associated financial insights behind these results.

Among the main findings, one result is of the most importance. To trend is to diversify in bad times. In good times, trend-following strategies offer no significant diversification power. Indeed, they are beta strategies. This is not a problem, since investors do not need to be diversified at all times. In particular, they do not need diversification in good times, because they do not want that the positive returns generated by some assets to be cancelled out by negative returns on other assets. This is why diversification may destroy portfolio performance in good times. Investors only need diversification in bad economic times and stressed markets.

This diversification asymmetry is essential when investing in beta strategies like alternative risk premia. On the contrary, this diversification asymmetry is irrelevant when investing in absolute return strategies. However, we know that generating performance with alpha strategies is much more difficult than generating performance with beta strategies. Therefore, beta is beautiful, but convex beta is precious and scarce. Among risk premia, momentum is one of the few strategies to offer this diversification asymmetry. This is why investing in momentum is a decision of portfolio construction, and not a search for alpha.

Keywords: Momentum, Trend-Following, Diversification, Payoff

JEL Classification: C50, C60, G11