Profitability of Risk-Managed Momentum in Equity Markets : Global Evidence

Abstract

The plain momentum strategy has been a profitable investment strategy for investors in many countries. Despite the success of the momentum strategies, the plain momentum is prone to momentum crashes. The momentum crashes can wipe out the returns of the decades, and it might take years that the plain momentum recovers from the crash. To improve momentum profitability and avoid the momentum crashes, Barroso and Santa-Clara (2015) present a risk-managed momentum strategy. This thesis examines whether the risk-managed momentum produces positive abnormal returns in European and global (North America, Japan and Asia-Pacific) equity markets. Furthermore, this thesis takes a deeper look at how managing the risk of the momentum reduces the momentum crash risk and increases the profitability measured by the Sharpe ratio.

This thesis utilizes only the data from the largest stocks, which comprise 90 % of the total market capitalization. All the data are downloaded from Kenneth French’s website, and the time period that is used is from January 1995 to December 2019. To construct the risk-managed momentum portfolios, this thesis uses the same procedure as Barroso and Santa-Clara (2015). In order to test the positive abnormal returns of the risk-managed momentum, the Ordinary Least Squares (OLS) regressions that utilize the Fama-French three-factor model (FF3) and Fama-French five-factor model (FF5) are run. Moreover, robustness tests are formed by dividing the whole sample period into four different subsamples.

The results of the whole sample period indicate that the risk-managed momentum strategy produces statistically significant positive abnormal returns in Europe and Asia-Pacific but not in North America and Japan. Even though managing the risk of the momentum does not produce statistically significant positive abnormal returns in all research regions, it provides other benefits for the investors. The risk-managed momentum produces higher Sharpe ratio compared to the plain momentum. The Sharpe ratio results are robust in every subsample and every research region. Usually, high kurtosis values are related to plain momentum strategy, but this thesis provides results that the risk-managed momentum drops the kurtosis values near to normal distribution. Furthermore, managing the risk of the momentum improves whole sample skewness values in every research area and even provides positive skewness values. Thus, this indicates that the risk-managed momentum virtually eliminates the momentum crashes.