Filtering market signals: dynamic asset allocation with momentum and hidden mean reversion

Sühan Altay, Katia Colaneri, Zehra Eksi-Altay and Eva Flonner

Quantitative Finance, 2026, vol. 26, issue 4, 593-613

Abstract: We study dynamic asset allocation when returns display short-run momentum yet revert to a hidden long-run mean. We extend the two-factor specification of [Koijen, R.S., Rodriguez, J.C. and Sbuelz, A., Momentum and mean reversion in strategic asset allocation. Manage. Sci., 2009, 55, 1199–1213.] into a partially observable linear-Gaussian economy. We estimate the unobservable drift of the return process with a Kalman–Bucy filter and exploit the separation principle to characterize the optimal portfolio and its value under partial information. The optimal weight splits into a myopic momentum bet, an intertemporal hedge, and an information-hedging component that scales with the filter's conditional error variance. Closed-form expressions for the indifference value of information show that the premium for perfect drift observability rises with the noise-to-signal ratio. A simulation study enables us to interpret our theoretical results, and a real data application reveals that the partial-information strategy behaves more smoothly, yet still outperforms a naïve benchmark.

Date: 2026
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DOI: 10.1080/14697688.2026.2627261

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