Strategic Allocation

Is there a best way to select and weight asset classes for long-term diversification benefits? These blog entries address this strategic allocation question.

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Simple Asset Class ETF Momentum Strategy as Diversifier

A subscriber inquired whether the “Simple Asset Class ETF Momentum Strategy” is a good diversifier of the U.S. stock market. This strategy allocates funds at the end of each month to the one (Top 1), equally weighted two (EW Top 2) or equally weighted three (EW Top 3) of the following asset class exchange traded funds (ETF) or Cash with the highest total return over the past five months:

PowerShares DB Commodity Index Tracking (DBC)
iShares MSCI Emerging Markets Index (EEM)
iShares MSCI EAFE Index (EFA)
SPDR Gold Shares (GLD)
iShares Russell 1000 Index (IWB)
iShares Russell 2000 Index (IWM)
SPDR Dow Jones REIT (RWR)
iShares Barclays 20+ Year Treasury Bond (TLT)
3-month Treasury bills (Cash)

To investigate, we first look at correlations between momentum strategy returns and those of SPDR S&P 500 ETF (SPY) and Vanguard Balanced Index Investor Shares (VBINX), with the latter maintaining an approximately 60% allocation to the broad U.S. stock market and a 40% allocation to the U.S. corporate bond market. We then generate return statistics for portfolios that hold equally weighted combinations of: (1) the Top 1 momentum strategy and SPY, and (2) Top 1 and VBINX. Using monthly dividend-adjusted returns for the specified funds and the monthly Treasury bills yield as a proxy for Cash during January 2003 through January 2015, we find that: Keep Reading

Options for Retirement?

Is use of long-term stock index call options effective for those approaching retirement with desires of limiting exposure to crashes without sacrificing all benefit of equity exposure? In his January 2015 paper entitled “Individuals Approaching Retirement Have Options (Literally) to Secure a Comfortable Retirement”, Bryan Foltice proposes retirement strategies that employ stock index options during the five years before retirement (when prospective retirees tend to become very risk-averse) to limit equity risk while retaining some reward. These alternatives to conventional (100% stocks, 60%-40% stocks-bonds and 100% minus age in stocks) asset allocation strategies put core funds in Treasury Inflation-Protected Securities (TIPS) to secure retirement income at a real 75% of final working income and funds in excess of the core to buy long-term at-the-money stock index call options. He considers three option-based strategies:

  1. Buy 5-year options at age 60.
  2. Buy a 3-year option at age 60 and a 2-year option at age 63.
  3. Buy 1-year call options each year using the final five annual contributions.

Base modeling assumptions use 1928-2013 historical return statistics, with robustness tests assuming (1) an increased equity risk premium and (2) expectations derived from 2014 data through October. Modeling includes expected costs/fees. Using simulations based on estimates for U.S. stock market capital gains/dividends and for the TIPS real yield, he finds that: Keep Reading

Optimal Monthly Cycle for Simple Debt Class Mutual Fund Momentum Strategy?

In reference to “Optimal Monthly Cycle for Simple Asset Class ETF Momentum Strategy?”, a subscriber asked about an optimal monthly cycle for the “Simple Debt Class Mutual Fund Momentum Strategy”. This latter strategy each month allocates the entire portfolio value to the one of the following 12 debt class mutual funds with the highest past total return (optimally over the last two months):

T. Rowe Price New Income (PRCIX)
Thrivent Income A (LUBIX)
Vanguard GNMA Securities (VFIIX)
T. Rowe Price High-Yield Bonds (PRHYX)
T. Rowe Price Tax-Free High Yield Bonds (PRFHX)
Vanguard Long-Term Treasury Bonds (VUSTX)
T. Rowe Price International Bonds (RPIBX)
Fidelity Convertible Securities (FCVSX)
PIMCO Short-Term A (PSHAX)
Fidelity New Markets Income (FNMIX)
Eaton Vance Government Obligations C (ECGOX)
Vanguard Long-Term Bond Index (VBLTX)

To investigate, we compare 21 variations of the strategy based on shifting the monthly return calculation cycle relative to trading days from the end of the month (EOM). For example, an EOM+5 cycle ranks funds based on closing prices five trading days after EOM each month. We use the historically optimal two-month fund momentum measurement interval. Using daily dividend-adjusted closes for the 12 funds during mid-December 1994 through mid-January 2015 (241 months), we find that: Keep Reading

Extended Simple Momentum Strategy Test of TSP Funds/Proxies

A subscriber asked about extending “Simple Momentum Strategy Applied to TSP Funds” back in time to 1988. That test employs the following five funds all available to U.S. federal government employees via the Thrift Savings Plan (TSP) starting in January 2001:

G Fund: Government Securities Investment Fund (G)
F Fund: Fixed Income Index Investment Fund (F)
C Fund: Common Stock Index Investment Fund (C)
S Fund: Small Cap Stock Index Investment Fund (S)
I Fund: International Stock Index Investment Fund (I)

S Fund and I Fund data limit the sample period. To extend the test back to first availability of G Fund, F Fund and C Fund data in February 1988 (January 1988 data is partial for TSP funds), we use Vanguard Small Cap Index Investors Fund (NAESX) as a proxy for the S Fund and Vanguard International Value Investors Fund (VTRIX) as a proxy for the I Fund prior to 2001. The subscriber requested first a sensitivity test of ranking intervals (one to 12 months), and then performance tests using the optimal ranking interval on portfolios consisting of the one fund with the highest past total return (Top 1), an equally weighted portfolio of the top two funds (EW top 2) and an equally weighted portfolio of the Top 3 funds (EW Top 3). Using monthly returns for the five TSP funds as available during February 1988 through December 2014 (323 months) and monthly returns for NAESX and VTRIX during February 1988 through December 2000, we find that: Keep Reading

Simple Asset Class ETF Momentum Strategy with SHY Return Filter

A subscriber suggested using iShares 1-3 Year Treasury Bond ETF (SHY) as a return filter for the“Simple Asset Class ETF Momentum Strategy” as a way to suppress maximum drawdown. The basic strategy each month allocates funds to the one, two or three of the following eight exchange-traded funds (ETF) plus cash, as proxied by U.S. Treasury bills (T-bills), with the highest returns over the past five months:

PowerShares DB Commodity Index Tracking (DBC)
iShares MSCI Emerging Markets Index (EEM)
iShares MSCI EAFE Index (EFA)
SPDR Gold Shares (GLD)
iShares Russell 1000 Index (IWB)
iShares Russell 2000 Index (IWM)
SPDR Dow Jones REIT (RWR)
iShares Barclays 20+ Year Treasury Bond (TLT)
3-month Treasury bills (Cash)

The T-bill yield is an approximation of the (non-negative) yield paid on cash by brokers. SHY can have negative returns in response to a rise in interest rates because it holds U.S. Treasury notes of terms 1-3 years. We investigate in two steps: (1) substitute SHY for T-bills in the basic strategy; and, (2) apply the SHY filter, substituting SHY for any winning ETF with a lower past return than SHY. Using monthly dividend-adjusted closing prices for the specified ETFs and the yield on T-bills during February 2006 (when all ETFs become available) through December 2014 (107 months), we find that:

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A Few Notes on A Random Walk Down Wall Street

In the preface to the eleventh (2015) edition of his book entitled A Random Walk Down Wall Street: The Time-Tested Strategy for Successful Investing, author Burton Malkiel states: “The message of the original edition was a very simple one: Investors would be far better off buying and holding an index fund than attempting to buy and sell individual securities or actively managed mutual funds. …Now, over forty years later, I believe even more strongly in that original thesis… Why, then, an eleventh edition of this book? …The answer is that there have been enormous changes in the financial instruments available to the public… In addition, investors can benefit from a critical analysis of the wealth of new information provided by academic researchers and market professionals… There have been so many bewildering claims about the stock market that it’s important to have a book that sets the record straight.” Based on a survey of financial markets research and his own analyses, he concludes that: Keep Reading

Simple Asset Class ETF Maximum Momentum Strategy

In an effort to generate more responsive exchange-traded fund (ETF) momentum switching, a subscriber proposed a version of the “Simple Asset Class ETF Momentum Strategy” that measures ETF returns from the lowest daily close within the momentum measurement interval rather than the monthly close at the beginning of the momentum measurement interval. To investigate, we run a competition between these alternative ways of measuring momentum as applied to the following eight asset class exchange-traded funds (ETF), plus cash:

PowerShares DB Commodity Index Tracking (DBC)
iShares MSCI Emerging Markets Index (EEM)
iShares MSCI EAFE Index (EFA)
SPDR Gold Shares (GLD)
iShares Russell 1000 Index (IWB)
iShares Russell 2000 Index (IWM)
SPDR Dow Jones REIT (RWR)
iShares Barclays 20+ Year Treasury Bond (TLT)
3-month Treasury bills (Cash)

Specifically, the baseline strategy allocates all funds at the end of each month to the ETF or cash with the highest total return over the past five months (5-1). The alternative strategy allocates all funds at the end of each month to the ETF or cash with the highest return measured from its low during the last 105 trading days (about five months) to the end of the current month (Max 5-1). Using daily dividend-adjusted closing prices for the asset class proxies and the monthly yield for Cash during July 2002 (or inception if not available then) through December 2014 (150 months), we find that: Keep Reading

Long-run Test of a Tactical, Tractable MPT

Does a cross-asset class, momentum-driven, simplified version of Modern Portfolio Theory (MPT) offer reliably strong performance over the long run? In their December 2014 paper entitled “A Century of Generalized Momentum; From Flexible Asset Allocations (FAA) to Elastic Asset Allocation (EAA)”, Wouter Keller and Adam Butler present an asset allocation strategy based on five concepts:

  1. MPT is a sound framework for portfolio construction.
  2. Momentum, a form of trend measurement, is a generally effective way to estimate key inputs to MPT: asset returns (R), return volatilities (V) and return correlations (C).
  3. Crash protection based on excluding assets with negative past returns is a reasonable corollary of reliance on trends.
  4. Tractability requires compromise to strict MPT, such as calculating return correlations relative to a single index (the equally weighted average returns of all assets).
  5. Recognition of differences in import among inputs means weighting R, V and C inputs differently according to their elasticities (how much small changes in R, V and C affect the optimal portfolio weight for the asset).

The fifth concept is the innovation relative to the Flexible Asset Allocation (FAA) predecessor (see “Asset Allocation Combining Momentum, Volatility, Correlation and Crash Protection”), which weights expected R, V and C inputs based on a simple scoring system. The new Elastic Asset Allocation (EAA) strategy each month scores all assets in a universe by: (1) calculating expected R, V and C for each asset as geometrically weighted averages of past values; and, (2) weighting the expected values of R, V and C by their respective elasticities. For R, they use average total monthly excess (relative to the 13-week U.S. Treasury bill yield) returns over the last 1, 3, 6 and 12 months. For V and C, they use the last 12 monthly returns. To test the EAA strategy, they each month reform a long-only portfolio of the top-ranked assets weighted by their respective scores. They replace a fraction of the portfolio with 10-year U.S. Treasury notes (selected empirically as the best “cash” asset) according to the fraction of assets in the universe with non-positive excess returns. They apply a nominal one-way index switching friction of 0.1%. They consider three universes of 7, 15 and 38 asset classes. They emphasize Calmar ratio (focusing on drawdown) as a key optimization metric, but also consider Sharpe ratio. To mitigate data snooping, they optimize elasticity parameters during April 1914 through March 1964 and test it out-of-sample during April 1964 through August 2014. Using monthly returns for the three sets of financial asset indexes as available during April 1914 through August 2014, they find that:

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Net Benefits of Diversification

Does diversification into alternative asset class investments, which may carry high management fees, help on a net basis? In the December 2014 version of their paper entitled “Fees Eat Diversification’s Lunch”, William Jennings and Brian Payne examine the diversification benefits of different asset classes after accounting for associated investment management fees. They focus on fees relative to allocation alpha, the expected return after accounting for market risk (volatility). Allocation alpha is a passive return derived from strategic allocation. They consider 45 asset classes with long-term (10-15 years) expected returns, risks and correlations per J.P. Morgan’s “Long-term Capital Market Return Assumptions.” They apply asset class investment management fees from a biennial fee survey performed by a major institutional investment consulting firm, segmented into three investor types: small endowment, state pension, and high-quality (fee-advantaged) foundation. Using the specified asset class performance estimates and associated investment management fees, they find that: Keep Reading

Simple Momentum Strategy Applied to TSP Funds

A subscriber asked about applying the “Simple Asset Class ETF Momentum Strategy” to the funds available to U.S. federal government employees via the Thrift Savings Plan (TSP). To investigate, we test the strategy on the following five funds:

G Fund: Government Securities Investment Fund (G)
F Fund: Fixed Income Index Investment Fund (F)
C Fund: Common Stock Index Investment Fund (C)
S Fund: Small Cap Stock Index Investment Fund (S)
I Fund: International Stock Index Investment Fund (I)

For baseline tests, we allocate at the end of each month to the fund with the highest total return over the past five months (5-1), an equally weighted portfolio of the top two funds (EW top 2) or an equally weighted portfolio of the Top 3 funds (EW Top 3). We also conduct a robustness test to assess ranking intervals other than five months. Using monthly returns for the five funds from initial availability of all five (January 2001) through November 2014 (167 months), we find that: Keep Reading

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