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Volatility weighting applied to momentum strategies

Volatility weighting applied to momentum strategies

13-01-2017 | Research
Volatility weighting is a form of risk management for investment strategies. When volatility is high, or low, the positions are scaled down, or up. This approach is commonly applied in practice by investors. But does this really add value?
  • Winfried  Hallerbach
    Winfried
    Hallerbach
    Senior Quantitative Researcher

Speed read

  • We apply volatility weighting to momentum strategies
  • Empirical evidence shows volatility weighting adds value
  • Novel dispersion weighting approach seems to be less effective

In this article,1 we consider two forms of volatility weighting—own volatility and underlying volatility—applied to cross-sectional and time-series momentum strategies. We present some simple theoretical results for the Sharpe ratios of weighted strategies and show empirical results for momentum strategies applied to US industry portfolios.

We find that both the timing effect and the stabilizing effect of volatility weighting are relevant. We also introduce a dispersion weighting scheme that treats cross-sectional dispersion as (partially) forecastable volatility. Although dispersion weighting improves the Sharpe ratio, it seems to be less effective than volatility weighting.

1Du Plessis, J. and Hallerbach, W. G., 2017, ‘Volatility weighting applied to momentum strategies’, The Journal of Alternative Investments.

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