Research Article #23 - Risk Premia harvesting Through Dual Momentum
In-Depth Review of a Paper Written in 2012 by Gary Antonacci
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Introduction
Momentum is a well-documented phenomenon in markets where assets that have performed well over a certain period have a tendency to continue to perform well into the future. This paper talks about two types of momentum:
Relative Momentum: This is when the performance of one asset is compared to other asset and its future performance is predicted based on its relative strength.
Absolute Momentum: This type of momentum is based on an asset’s own past behavior to predict its future performance. An asset that exhibits positive absolute momentum if its excess return is positive over a look-back period, and doesn’t take into consideration performance from another asset.
Momentum can be found in a variety of asset classes such as foreign stocks, emerging markets, equity indices, currencies, corporate bonds and even residential real estate. However despite the abundance of momentum research and general acceptance, no one is quite sure why it works. One of the rational takes is that momentum profits represent risk premia because winners are riskier than losers. Other arguments around behavioral factors like anchoring, herding and disposition effects are also used to try and explain this market phenomena.
The goal presented in this paper is to show what happens when relative strength price momentum is combined with trend following absolute momentum or what is called a Dual Momentum Strategy. A Dual Momentum strategy involves selecting assets based on their relative strength but also ensuring that they show positive absolute momentum. If an asset doesn’t show positive absolute momentum, Treasury bill are used as the default investment until the asset shows both relative and absolute momentum.
One added benefit is that when market conditions are not the most favorable, the Treasury bills offer a safer alternative investment while also imposing diversification in the momentum portfolio. If only trading a absolute momentum model, one could have a well-diversified portfolio of multiple assets but with relative strength momentum, some assets may drop of the active portfolio. The argument against the absolute momentum only portfolio, is that, if we got all assets under one large pot, select the top momentum performers, all or most of the positions could be highly correlated with each other.
Momentum Scores (Blue Bars): Each asset (A through E) has a hypothetical momentum score, with higher scores indicating better performance based on momentum. These scores represent how well each asset is performing currently relative to its past performance.
Correlation with Portfolio (Red Line): Alongside each asset's momentum score is its correlation with the overall portfolio. This correlation is a measure of how each asset's movements are related to the movements of the portfolio as a whole.
Key Insight: The trend shown in the graph is that assets with higher momentum scores tend to have higher correlations with the portfolio. This means that if a portfolio is constructed solely based on selecting top momentum performers, it might end up being composed of assets that are highly correlated with each other.
Risk Implication: High correlation among assets in a portfolio can be risky. If these correlated assets all experience a downturn, the entire portfolio could suffer significantly. Diversification is compromised in such a scenario, as the assets would tend to move in the same direction.
Index
Introduction
Index
The Strategy and Results
Closing Remarks
Code
References/Sources
Disclaimer
The Strategy and Performance
