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Stock Momentum Strategy Risk Management with and without Leverage

Posted in Momentum Investing, Volatility Effects

What aspect of momentum strategy volatility is best for risk management? In his July 2017 paper entitled "Risk-Managed Momentum: The Effect of Leverage Constraints", Federico Nucera examines stock momentum strategy risk management via different aspects of realized strategy variance with and without latitude for leverage. Specifically, he considers the following stock momentum strategy variations:

  1. Conventional - each month long (short) the value-weighted tenth, or decile, of stocks that are the biggest winners (losers) last month per Kenneth French's specifications.
  2. Full Variance Weighting - each month weighting the conventional momentum portfolio by 1.44% (12% annual volatility) divided by the full variance of daily conventional momentum strategy returns over the past six months.
  3. Positive Semi-variance Weighting - each month weighting the conventional momentum portfolio by 0.68% divided by the semi-variance of positive daily conventional momentum strategy returns over the past six months.
  4. Negative Semi-variance Weighting - each month weighting the conventional momentum portfolio by 0.76% divided by the semi-variance of negative daily conventional momentum strategy returns over the past six months.

For each variation, he considers full weights (leverage), weights limited to 1.5X leverage and weights limited to 1.0X (no leverage). He focuses on gross annualized Sharpe ratio as the key performance metric. Using daily and monthly value-weighted momentum decile portfolio returns for a broad sample of U.S. stocks during November 1926 through December 2016, he finds that:

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