Testing Volatility-Based Allocation with ETFs

Posted in Technical Trading, Volatility Effects


A subscriber suggested review of Empiritrage’s Volatility-Based Allocation (VBA). This strategy applies two monthly signals to an equally weighted portfolio of asset class total return proxies to determine whether to be in each proxy or cash, as follows:

  • Step 1: If the 10-day simple moving average (SMA) of the S&P 500 Volatility Index (VIX) is above its 30-day SMA (risk off), substitute the risk-free asset for all asset class proxies.
  • Step 2: If the 10-day simple moving average (SMA) of VIX is below its 30-day SMA (risk on), invest in each asset class proxy for which the respective two-month SMA is above the 12-month SMA, and otherwise in the risk-free asset.

Empiritrage’s simulation of VBA employs equal allocations each month to each of five asset class proxies (U.S. stocks, non-U.S. developed market stocks, emerging market stocks, real estate and long-term U.S. government bonds) or to U.S. Treasury bills (T-bills) as signaled, ignoring trading frictions, during March 1986 through August 2012. They find that VBA “dominates” an allocation based only on individual asset class proxy SMAs. However, indexes do not account for the costs of maintaining tradable assets, and the costs of switching between risk assets and cash may be material. For another perspective, we replicate VBA (with switching frictions) using the following exchange-traded funds (ETF) and estimated return on cash:

SPDR S&P 500 (SPY)
iShares MSCI EAFE Index (EFA)
iShares MSCI Emerging Markets Index (EEM)
iShares Barclays 20+ Year Treasury Bond (TLT)
3-month Treasury bills (risk-free rate)

Using daily closes for VIX since March 2003 and monthly closes for the ETFs and risk-free rate since April 2003 (limited by inception of EEM), we find that: (more…)

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