Hedging the time-varying risk exposures of momentum returns

• Momentum has time-varying exposures depending on past equity risk factor returns.
• Hedging these exposures increases the Sharpe ratio of momentum from 0.36 to 0.71.
• Hedged momentum returns vary less over the business cycle and market conditions.
• Estimates of momentum stocks' individual betas are systematically biased.
• The conditional hedge based on past factor returns provides the best hedge.

Momentum returns have time-varying exposures to the three Fama and French equity risk factors. In particular factor loadings are higher when the factor returns during the ranking period are higher. In this study we look at momentum returns after hedging these time-varying exposures to the Fama and French factors. We find that specifically taking into account the conditional nature of the time-variation in factor loadings is the best way to hedge. The hedged momentum returns are higher, less risky, more stable over time and vary less over different market conditions. Determining momentum betas based on estimated individual stock betas leads to systematic biases and hence is less effective in hedging.