01 Aug Learning From Quest Partners' "Know Your Skew"

Momentum strategies, with frequent small gains and losses and occasional large gains, are inherently positively skewed.

In this article, Absolute Momentum will be used interchangeably with trend following or time series momentum. Relative Momentum will be used interchangeably with cross-sectional momentum or relative strength.

Skew is a measure of asymmetry of return distribution.

Positive skew is the ability to have lower volatility than average when losing money and higher volatility when making money. Negative skew is the opposite; it is the characteristic of having higher volatility than average when losing money and lower volatility when making money.

A set of returns made up of frequent small, lower than average, returns and occasional large gains would be positively skewed. Conversely, a set of returns with frequent small, above average, returns and occasional large losses would be negatively skewed.

The paper shows that negatively skewed strategies are only attractive during stable market regimes. During market shocks (i.e., the three largest SP500 drawdowns in the past 17 years), low skew strategies display:

• outsized losses of -41% (vs. gains of +39% for high skew strategies);
• increases in correlation to the SP500; and
• increases in correlation to each other.

During their three worst drawdowns, low skew strategies lose 4.2 times their ex-ante (preceding) volatility while high skew strategies lose 2.3 times their ex-ante volatility. For low skew strategies, historical volatility is inadequate for estimating the risk of future loss.

During their three worst drawdowns, the strategies with high Sharpe ratios lose 4.3 times their ex-ante volatility, while the strategies with low Sharpe ratios lose only 2.2 times their preceding volatility.

Short-term and intermediate-term trend following strategies employed by CTAs exhibit inherently positive skew.

Research Paper: Know Your Skew: Using Hedge Fund Return Volatility as a Predictor of Maximum Loss

Authors: Nigol Koulajian, Paul Czkwianianc

Company: Quest Partners