Stock Momentum Strategy Risk Management Horse Race

What is the best risk management approach for a conventional stock momentum strategy? In their August 2019 paper entitled “Enhanced Momentum Strategies”, Matthias Hanauer and Steffen Windmueller compare performances of several stock momentum strategy risk management approaches proposed in prior research. They use the momentum factor, returns to a monthly reformed long-short portfolio that integrates average returns from 12 months ago to two months ago with market capitalization, as their base momentum strategy (MOM). They consider five risk management approaches:

1. Constant volatility scaling with 6-month lookback (cvol_6M) – scales the base momentum portfolio to a constant target volatility (full sample volatility of the base strategy) using volatility forecasts from daily momentum returns over the previous six months (126 trading days).
2. Constant volatility scaling with 1-month lookback (cvol_1M) – same as cvol_6M, but with volatility forecasts from daily momentum returns over the previous month (21 trading days).
3. Dynamic volatility scaling estimated in-sample (dyn_IS) – enhances constant volatility scaling by also forecasting momentum portfolio returns based on market return over the past two years using the full sample (with look-ahead bias).
4. Dynamic volatility scaling estimated out-of-sample (dyn) – same as dyn_IS, but with momentum portfolio return forecasts from the inception-to-date market subsample.
5. Idiosyncratic momentum (iMOM) – sorts stocks based on their residuals from monthly regressions versus market, size and value factors from 12 months ago to one month ago (rather than their raw returns) and scales residuals by monthly volatility of residuals over this same lookback interval. 

They evaluate momentum risk management strategies based on: widely used return and risk metrics; competition within a mean-variance optimization framework; and, breakeven portfolio reformation frictions. Using monthly and daily returns in U.S. dollars for U.S. common stocks since July 1926 and for common stocks from 48 international markets since July 1987 (July 1994 for emerging markets), all through December 2017, they find that: (more…)