Asset Allocation Combining Momentum, Volatility, Correlation and Crash Protection
January 2, 2013
Does combining different portfolio performance enhancement concepts actually improve outcome? In their December 2012 paper entitled “Generalized Momentum and Flexible Asset Allocation (FAA): An Heuristic Approach”, Wouter Keller and Hugo van Putten investigate the effects of combining momentum, volatility and correlation selection criteria to form an equally weighted portfolio of the three best funds from a set of mutual fund proxies for seven asset classes, as follows:
- To follow trend, rank funds from highest to lowest lagged total return (relative momentum).
- To suppress volatility, rank funds from lowest to highest volatility (standard deviation of daily returns).
- To enhance diversification, rank funds from lowest to highest average pairwise correlation of daily returns.
- To avoid drawdown, replace with cash any selected fund that has a negative lagged return (intrinsic or absolute momentum).
Their seven asset class proxies are index mutual funds for U.S. stocks (VTSMX), developed market stocks outside the U.S. and Canada (FDIVX), emerging market stocks (VEIEX), mid-term U.S. Treasuries (VBMFX), short-term U.S. Treasuries (VFISX), commodities (QRAAX) and real estate (VGSIX). They use a default lagged measurement interval of four months for all four selection criteria. Their method of combining rankings for relative momentum, volatility and correlation is simple weighted average (with default weightings of 1, 0.5 and 0.5, respectively). They assume momentum calculations occur at the end of each month, with portfolio changes at the beginning of the next month. Using daily closing prices in U.S. dollars for the seven mutual funds from mid-1997 through mid-December 2012, they find that: (more…)