ENHANCING MOMENTUM PROFITS THROUGH VOLATILITY TIMING AND COST MITIGATION TECHNIQUES

Abstract

Despite the high expected returns of the momentum strategy, there are two main problems associated with it: (i) infrequent but severe losses known as momentum crashes, and (ii) high transaction costs. In this paper, we address the first problem with volatility timing strategies developed by Daniel and Moskowitz (2016) and Moreira and Muir (2017). Our results prove that not only are momentum crashes alleviated but returns on the WML (winner-minus-loser) portfolios formed with these strategies also go up remarkably compared to the simple buy-and-hold ones. However, like the simple momentum strategy, volatility timing strategies suffer from large trading costs. We, therefore, propose combining these momentum strategies with the buy/hold spread cost-mitigation strategy formed by Novy-Marx and Velikov (2015). The outcome is a noticeable reduction in turnover and transaction costs, together with an improvement in the portfolio returns.