OLZ Publication in The Journal of Portfolio Management

Portfolio Construction with Hierarchical Momentum

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https://www.pm-research.com/content/iijpormgmt/50/4/136

Investors often turn to high-momentum stocks to capitalize on the momentum premium, seeking enhanced returns in their portfolios. However, this pursuit of momentum gains can come at a cost, particularly during bear market regimes, where high drawdowns can erode gains. This drawback is primarily attributed to the lack of diversification in classical momentum portfolios, where investments are concentrated in stocks highly correlated with each other.

Recognizing the need for enhanced diversification to stabilize portfolio performance and mitigate risk, the application of hierarchical clustering to a momentum portfolio emerges as a promising solution. By partitioning the market into groups of stocks exhibiting high intra-group correlation and low inter-group correlation, this approach aims to enforce diversification. Consequently, the momentum strategy is directed towards a broad spectrum of these diversified groups, ensuring that the portfolio comprises stocks with minimal correlation to each other.

Empirical research, as illustrated in Figure 1 and Table 1, supports the effectiveness of integrating momentum investing with hierarchical clustering. The study reveals a notable enhancement in portfolio stability, marked by reduced drawdowns inherent in traditional momentum portfolios. Consequently, this integration not only strengthens cumulative returns but also enhances risk-adjusted returns, underscoring the potential of clustering to improve portfolio performance.

In conclusion, the integration of momentum investing with hierarchical clustering represents a compelling approach to address the shortcomings of classical momentum portfolios. By prioritizing diversification and minimizing correlation among portfolio holdings, this strategy offers a pathway to stabilize performance and mitigate risk. As investors navigate dynamic market conditions, embracing innovative techniques such as hierarchical clustering can serve as a cornerstone for building resilient and robust investment portfolios.