Publication type: Working paper
Across numerous asset classes, momentum strategies have historically generated high returns, high Sharpe ratios, and strong positive alphas relative to standard asset pricing models. However, the returns to momentum strategies are skewed: they experience infrequent but strong and persistent strings of negative returns. These momentum "crashes" are forecastable: they occur following market declines, when market volatility is high, and contemporaneous with market "rebounds." The data suggest that low ex-ante expected returns in crash periods result from a conditionally high premium attached to the option-like payoffs of the past-loser portfolios. We show that an implementable dynamic strategy based on our analysis generate a Sharpe-ratio approximately double that of the static momentum strategy. Finally, we show that the anomalous returns to momentum strategy are correlated with but not explained by volatility risk.
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