Managing Momentum

Hedging the downside risks

Two weeks ago we wrote about some of the risks associated with Momentum strategies - you can read it here.

This week we’ll like to talk about how do you manage those risks associated Momentum factor strategies.

To be clear, we really like Momentum, it’s easily understandable and one of the most persistent and investable factor strategies. Momentum produced alpha across markets and market segments for a long period of time. It’s also versatile and can be applied through many universes with filters and twists. Also, when the markets are in a bull run, Momentum is the place to be because it will take you high along with the tide. As we said we really like it.

However, there are times Momentum can seem like a high-risk strategy. Like many periods in the past has shown.

So this week’s post is about managing these risks.

Managing your expectations

There are years that momentum does well. It can produce 40%+ returns or even 100%+ if it’s recovering from a sharp drawdown. It’s important first to understand that momentum is unlikely to produce 30%+ returns year after year. That’s extremely unlikely. But over the long run, the returns will be less spectacular. You should expect returns to normalize.

If a momentum strategy over the long run can create alpha in the range of +3-5% after costs and taxes over the benchmark, that’s a good strategy. 8-10% range will be great.

Avoid small-caps and micro-caps

When investing it’s generally a good idea to stick to a core portion of your portfolio in large caps and smaller satellite portfolio to mid-caps. And generally, a bad idea to invest significant sums in small caps and better to stay away from micro-caps.

The reasons for this are:

  • Larger drawdowns: Smallcaps tend to have much larger drawdowns than large caps. Adding momentum to that mix will lead to even more volatility and that’s better avoided.

  • More scope for market manipulation: Smallcaps tend to be easily driven by a few hands and hence price action is easier to manipulate by operators and hence unreliable.

  • Liquidity: When small caps tumble, they tend to be in a downward freeze, where it becomes hard to impossible to exit a position at an appropriate price and you’ll likely sell at a price much lower than you intended.

  • Poorer quality companies in general: investing a significant amount in a portfolio of small-cap stocks might be prone to risks because corporate governance or quality of results or strong growth in broad-based smallcap stocks is unusual or cyclical. So avoid.

Asset Allocation

Shyam and I agree this is one of the most important ways to stay within your comfort zone not just with momentum strategies but investing in equities in general. Allocating 20%-80% in debt based on your risk tolerance and your objectives will reduce volatility to within your comfort zone.

It will also minimize sequential risks. By sequential risks we mean, suppose if you needed a lumpsum amount next year to make an important payment and something happens that takes the market down by 30%. You won't be able to make that payment if that amount is deployed 100% in equities.

Portfolio diversification

Shyam and I agree this is one of the most important ways to stay within your comfort zone not just with momentum strategies but investing in equities in general. Allocating 20%-80% in debt based on your risk tolerance and your objectives will reduce volatility to within your comfort zone.

Diversifying within equities won’t eliminate all risks since when you invest in equities, your return is relative to the overall market return. You can underperform or outperform it but that’s a primary driver of the direction of your returns.

To minimize risks from general equity drawdowns, that’s why you have to diversify asset allocation to debt, gold, and derivatives (more in a bit).

Stop-losses

A momentum strategy with stop losses makes sense where you want a more adaptive asset allocation. Whereas stop losses get triggered and there are no alternative stocks that rank in momentum, you go to cash.

There are pros and cons to having narrow stop-losses or deep stop losses. And that requires a discussion on its own. But narrow stop losses will get triggered sooner, more prone to whipsaws and higher transaction costs but should provide considerable protection against a severe market correction. For deeper stop losses, it’s the opposite.

Whether it’s narrow or deep, we urge participants to adopt a trailing stop loss as the stock moves higher, the stop trails it and when it starts to fall at some point it cuts the position.

Also, once you decide to use stop-losses it’s important to follow it with discipline. Our emotional bias gets in our way where we hope that the stock will recover from here because the correction has been sharp or things are looking good but it’s important to implement the strategy consistently as devised. If possible, it’s better to automate this part.

An example of this is the All Star Strategy, compare the drawdowns between that, Nifty and Midcap index.

Hedging with Derivatives

A caveat first, we don’t recommend this to everyone.

  • Derivatives can be risky if you don’t know what you’re doing.

  • it’s generally a bad idea without a strategy that’s extensively tested especially during stressful times and has adequate risk management rules.

  • The account sizes need to be large.

  • And needs constant monitoring since the risks are real.

However, derivatives when used appropriately can provide a significant hedge against downside risks.

There are many ways to do this such as buying put options that protect against a downturn, which can work but is expensive and your win/loss ratio will be like 5%. The 5% times you will be large but might not suit everyone.

However, the way we like to do this is by having a short nifty position that is equivalent to the overall beta of the portfolio and almost equal to the size of the All Star Momentum Portfolio. And this has worked great.

We do provide customized solutions or to creating an investment strategy that suits your personal needs or offering access to unique strategies like Momentum with derivatives hedge.

With capital requirements starting at Rs. 20 lakhs, our Market-Neutral All Star (Futures) strategy is a no-brainer if you are looking for a long-term allocation towards levered momentum strategies. If you are interested in exploring this further, please reach out to Shyam at shyam.sunder@freefloat.in or me, at kishan.nair@freefloat.in

Happy Independence Day!