Adjusted momentum

What Is Adjusted Momentum?

Adjusted momentum is a quantitative investment strategy that refines the traditional momentum strategy by incorporating risk considerations, typically volatility, into the selection and weighting of assets. While standard momentum focuses purely on past price performance, adjusted momentum seeks to enhance risk-adjusted return by favoring securities that exhibit strong returns with lower associated risk, or by dynamically allocating based on expected volatility. This approach falls under the broader umbrella of factor investing, aiming to capture the well-documented momentum premium while mitigating its significant downside risks. The objective of adjusted momentum is to achieve more consistent performance and reduce the likelihood of severe drawdown events that can plague naive momentum portfolios.

History and Origin

The concept of momentum in financial markets gained widespread academic recognition following the seminal 1993 paper by Narasimhan Jegadeesh and Sheridan Titman, "Returns to Buying Winners and Selling Losers: Implications for Stock Market Efficiency." This research empirically demonstrated that stocks with strong past performance tended to continue to outperform, while those with poor past performance continued to underperform over intermediate horizons of 3 to 12 months.⁶ While this discovery established momentum as a prominent market anomaly, subsequent research highlighted a critical vulnerability: momentum strategies are prone to "crashes" or sudden, sharp reversals, particularly after market declines and during periods of high market volatility.⁵

These significant drawdowns prompted researchers and practitioners to explore modifications to the basic momentum approach. The development of adjusted momentum strategies emerged from the need to address these tail risks. Academics like Kent Daniel and Tobias Moskowitz, among others, demonstrated that momentum crashes are partly forecastable, often occurring in "panic" states characterized by high market volatility and following market downturns.⁴ This insight led to the formulation of dynamic momentum strategies that adjust exposure based on changing market conditions or incorporate volatility directly into the asset selection process, thereby giving rise to the various forms of adjusted momentum.

Key Takeaways

• Adjusted momentum enhances traditional momentum by integrating risk considerations, such as volatility, into the asset selection and weighting process.
• The primary goal of adjusted momentum is to improve risk-adjusted returns and reduce exposure to significant momentum crashes.
• It seeks to achieve more consistent performance compared to naive momentum strategies, which can suffer severe drawdowns.
• Adjusted momentum strategies often involve dynamic allocation or volatility-scaling to manage exposure to the momentum factor.
• While mitigating risks, adjusted momentum may sometimes reduce the raw returns experienced during strong momentum phases.

Formula and Calculation

Adjusted momentum strategies typically modify the ranking or weighting process of a standard momentum calculation. One common approach involves scaling returns by volatility. For example, a volatility-adjusted momentum score for an asset might be calculated as:

Where:

• Past Returns refers to the cumulative return of the asset over a look-back period (e.g., the last 12 months, excluding the most recent month).
• Past Volatility represents the standard deviation of the asset's daily or weekly returns over the same look-back period.

This formula produces a Sharpe ratio-like measure for each asset, prioritizing those that have delivered strong returns with relatively low fluctuations. In a portfolio management context, assets with higher adjusted momentum scores would receive a greater weight in the portfolio, or would be selected over assets with lower scores, even if their raw past returns were similar but their volatility higher.

Another method for adjusted momentum might involve dynamically allocating capital to the momentum strategy based on a market-wide volatility signal. For instance, reducing exposure to momentum during periods of high market stress and increasing it during calmer periods.

Interpreting the Adjusted Momentum

Interpreting adjusted momentum involves evaluating not just the magnitude of past price changes but also the smoothness and consistency of those changes. A higher adjusted momentum score suggests that an asset has delivered strong performance relative to the risk it has exhibited. This is particularly valuable for investors seeking strategies with more stable equity curves and fewer large swings.

For example, two stocks might have both gained 20% over the past year. However, if Stock A achieved this with minor daily fluctuations while Stock B experienced wild swings up and down before ending at a 20% gain, Stock A would likely have a higher adjusted momentum score due to its lower volatility. Investors using adjusted momentum would interpret Stock A as a more desirable holding from a risk-efficiency perspective, as it suggests a more robust or less speculative trend. This approach helps in building a more resilient asset allocation and diversification within a portfolio.

Hypothetical Example

Consider an investor evaluating two hypothetical exchange-traded funds (ETFs) for an adjusted momentum strategy over a 12-month look-back period:

ETF A:

• Cumulative Return: +15%
• Annualized Volatility: 10%

ETF B:

• Cumulative Return: +18%
• Annualized Volatility: 15%

Using the basic adjusted momentum score formula:

For ETF A:

For ETF B:

Even though ETF B had a higher raw return (+18% vs. +15%), its higher volatility resulted in a lower adjusted momentum score (1.2 vs. 1.5). An adjusted momentum strategy would favor ETF A because it generated its returns with less risk, suggesting a more efficient upward trend. This illustrates how adjusted momentum aims to identify "quality" momentum, rather than just raw performance, contributing to more stable portfolio performance through careful portfolio management.

Practical Applications

Adjusted momentum is extensively applied in quantitative analysis and automated trading systems where investors seek to systematically identify and exploit price trends while maintaining risk controls. It is particularly relevant for institutional investors and hedge funds that manage large portfolios and require strategies with predictable risk-adjusted return profiles.

One common application is in dynamic asset allocation models, where the allocation to various asset classes (e.g., equities, bonds, commodities) is adjusted based on their volatility-adjusted momentum. This can help investors rotate into asset classes that are performing well with lower risk, potentially avoiding the sharp reversals that impact traditional momentum. For example, some approaches reduce exposure to the momentum factor during periods of high systemic market volatility to minimize exposure to potential momentum crashes.³ This proactive risk management is a key differentiator, aiming for more consistent alpha generation.

Limitations and Criticisms

While adjusted momentum aims to mitigate some of the inherent weaknesses of traditional momentum, it is not without its limitations. One significant critique is that by introducing risk adjustments, the strategy may, in some periods, dilute the strong raw returns that pure momentum can deliver during sustained bull markets. The very act of reducing exposure during high-volatility periods, even if those periods precede market rebounds, could lead to missed opportunities for significant gains.²

Another challenge lies in the look-back periods and the specific volatility measures chosen for the adjustment. Different parameters can lead to vastly different adjusted momentum scores and, consequently, different portfolio compositions and performance. Furthermore, while the concept aims to reduce "momentum crashes," these events can still occur, and no strategy can entirely eliminate systematic risk or unforeseen market shocks. The effectiveness of adjusted momentum also relies on the premise that past volatility is a reliable indicator of future risk, which is not always guaranteed. Morningstar notes that despite empirical evidence showing momentum strategies offer significant returns, they also display "huge tail risk" and that crashes "occurred particularly in reversals from bear markets when the momentum portfolio displayed a negative market beta and momentum volatility was high."¹ This underscores that even with adjustments, momentum strategies require careful monitoring and understanding of their underlying behavioral finance underpinnings.

Adjusted Momentum vs. Price Momentum

The core distinction between adjusted momentum and price momentum lies in the consideration of risk.

While price momentum simply ranks or selects assets based on their past percentage gains, adjusted momentum refines this by penalizing highly volatile assets or reducing exposure during periods of elevated market uncertainty. The underlying premise of price momentum is that "winners keep winning," often attributed to investor under-reaction to information. Adjusted momentum, conversely, attempts to address the "dark side" of this phenomenon by explicitly managing the volatility component that can lead to large, sudden reversals, making it a more sophisticated approach for factor investing.

FAQs

Why is adjusting momentum important?

Adjusting momentum is crucial because traditional momentum strategies, while profitable on average, are susceptible to severe and infrequent "crashes" where they experience significant losses. Incorporating risk adjustments, often through volatility control, helps to mitigate these large drawdowns and produce more stable, consistent risk-adjusted return.

How does adjusted momentum typically reduce risk?

Adjusted momentum typically reduces risk by either weighting assets inversely to their volatility or by dynamically reducing exposure to momentum during periods of high market stress and uncertainty. This aims to avoid or lessen the impact of sudden market reversals that can heavily penalize a pure momentum strategy.

Can adjusted momentum outperform pure momentum?

Adjusted momentum may not always achieve higher raw returns than pure momentum, especially during strong, uninterrupted upward trends in the market. However, its primary goal is to deliver superior risk-adjusted return and lower overall portfolio volatility, potentially leading to better long-term compounding by avoiding large losses.

Is adjusted momentum a form of market timing?

Some adjusted momentum strategies, particularly those that dynamically adjust exposure based on market-wide volatility or other risk signals, can be seen as a form of market timing. They attempt to time exposure to the momentum factor itself, rather than timing the broader market, by reducing or increasing allocation based on anticipated risk conditions.

What are common types of adjustments used in momentum?

Common adjustments in momentum strategies include volatility scaling (dividing past returns by past volatility), risk-parity weighting (allocating capital to normalize risk contributions from each asset), and conditional strategies that reduce or turn off momentum exposure during periods of high market systematic risk or during "panic" states.