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Reader Bob Tait of Houston suggested a review of the free Decision Moose asset allocation framework of William Dirlam. "Decision Moose is an automated framework for making intermediate-term investment decisions." Decision Moose focuses on asset class momentum, as augmented by monetary policy, exchange rate and interest rate indicators. Its signals tell followers when to switch from one index fund to another among nine encompassing a broad range of asset classes, including equity indexes for several regions of the globe. The trading system presented is a long-only approach that allocates 100% of funds to the index "having the highest probability of price appreciation." The site includes a history of switch recommendations since the end of August 1996. Mr. Dirlam provides background on the site and the Decision Moose framework via FAQs. To evaluate the framework, we assume that the 44 switches and trading returns are as described (out of sample, not backtested) and compare the returns to those for the S&P 500 index over the same trading intervals (with open positions closed as of 7/20/07). We find that:
The following chart summarizes results by trade for all 44 Decision Moose trades and comparable S&P 500 index trades. Trade 44 is closed on 7/20/07 for analysis purposes, even though Decision Moose currently holds the trade open. Results exclude trading fees and other frictional costs. A comparison like this is reasonable because Decision Moose remains continuously and fully invested in one fund or another.
Does Decision Moose investing have a hedging effect?
The following scatter plot offers a different perspective on the same data. The data point at the upper left of the plot is the Trade 18 outlier noted above. Visual inspection indicates that Decision Moose often generates gains when the S&P 500 index has losses. The Pearson correlation between the two series is 0.01, indicating no relationship and implying good hedging. However, excluding the Trade 18 outlier increases this correlation to 0.43, indicating some positive link between Decision Moose results and the performance of U.S. stocks. The large change in correlation caused by excluding just one data point says the sample is somewhat small for deciding the strength of the relationship.
In his FAQs, Mr. Dirlam suggests that Decision Moose trading is best suited to a reasonably large tax-deferred account to minimize the impacts of trading costs and taxes. He also offers guidance on the type of investor for whom Decision Moose is suitable.
In summary, the Decision Moose asset allocation framework may offer investors a way to beat buying and holding broad U.S. equity indexes by occasionally trading to the "hottest hand" from a broad set of asset classes.
It is plausible that investing across asset classes and around the globe amplifies and extends momentum by exploiting the reluctance of some (most?) investors to go outside their investing comfort zones. However, this amplification of momentum might diminish with time as investors think more globally.
For related research, see Blog Synthesis: Momentum Investing/Trading and Blog Synthesis: Reviews of Books and Web Sites. See especially our blog entries of 2/27/07 and 2/15/07 on somewhat comparable momentum-based asset class trading systems.
