Risk management has taken the money management business by storm. If you run money, you have to say that you control volatility and manage the risk. It is the equivalent of saying, “I love my mother and apple pie.” If risk goes up, you have to cut position exposure or at least that is what many will say is the path to good returns. Nevertheless, the empirical testing of this truism could be improved. A recent paper in the Journal of Alternative Investments called, “Volatility Weighting Applied to Momentum Strategies” looks at this important question in detail and concludes that it does help at improving the return to risk.

The authors provide a theoretical framework to explain when and why volatility weighting will work with momentum strategies. If there is an inverse relationship between momentum and volatility, then volatility weighting will generally be effective. That is, if there is a predictable link between strategy returns and volatility, weighing will be helpful. The authors provide both necessary and sufficient conditions for when volatility weighting makes sense and distinguishing between timing and stability effects for volatility weighting. If that relationship does not exit, the impact of weighting will be ambiguous. Using volatility weighting without understanding the price dynamics within markets does not make sense.

Looking at momentum strategies through a broad set of 49 industry portfolios, the authors study the impact of volatility weighting for both market and portfolio level schemes across different time periods. The results conclude that volatility weighting makes good sense. The data show that volatility weighting will improve Sharpe ratios, reduce kurtosis, and reduce average drawdowns as well as just reduce overall volatility. These results apply to both strategy volatility and schemes looking at underlying or normalized market returns. Nevertheless, volatility controls can be unstable over time and may require more careful analysis especially with extrapolation this work to global macro.

Maximizing the return to risk may not be the true objective for holding trend-following or momentum managed futures strategies. The unique feature of managed futures is its ability to generate positive skew or crisis alpha. You buy managed futures trend-following not to get the best return to risk but to have an investment strategy that will do well in “bad times”. The results with respect to skew through looking at the difference between the mean less median returns are slightly ambiguous for this study.

A smoothing strategy that takes out the skew or crisis beta may make trend-following in managed futures more similar to other investments strategies. I am all for volatility control and cutting position sizes when the return to risk is no longer favorable, but too much smoothing may throw out the crisis alpha with the bath water.