Momentum plus - Control volatility or other factors and risk-adjusted returns are improved

Investors should exposure to equity momentum strategies. Momentum has been shown to be one of the core style factors available to investors, but all momentum strategies are not created equal. There is a level of craftsmanship required to create a good momentum strategy. How the momentum strategy is structured will have significant impact on returns and Sharpe ratio. 

A recent paper, "Enhanced Momentum Strategies" by Matthias X. Hanauer and Steffen Windmuller has looked at different approaches to gaining exposure to a momentum style using the same database and time period so clear comparisons can be made. The results are stark. A simple momentum strategy will do well but it is subject to crashes during periods of strong market stress.  There can be significant improvement through accounting or adjusting for volatility. 

The authors test a constant volatility and a dynamic scaling approach. The constant volatility attempts to target volatility at a fixed level, while the dynamic scaling accounts for changing Sharpe ratio to adjust positioning. Both show improvement over no volatility adjustments. 

However, what may be the best approach is looking at idiosyncratic momentum or momentum measured after accounting for the original three factors that have been identified by Fama and French. Once momentum is measured on the residuals after accounting for the Fama and French factors, there is further improvement in the overall performance. However, even accounting for other factors suggests that momentum has had a difficult period post the Financial Crisis.

There is a recurring theme with all quantitative strategies. For momentum and trend, increased volatility is negatively correlated with  returns. Control the volatility and you will be able to improve the risk-adjusted returns. This improvement is all part of the craftsmanship of building enhanced models beyond the original style factor.