Strategic Allocation

Are popular exchange-traded products (ETP) such as VXX (iPath S&P 500 VIX Short Term Futures) and VXZ (iPath S&P 500 VIX Mid-Term Futures), designed to track specific S&P 500 VIX futures constant maturity index series, good hedges for stock portfolios? In their June 2012 paper entitled “Are VIX Futures ETPs Effective Hedges?”, Geng Deng, Craig McCann and Olivia Wang investigate whether these ETPs effectively hedge basic U.S. stock portfolios or exchange-traded funds (ETF) that leverage U.S. stock market indexes. Because the ETPs are only very recently available, they use the one-month (SPVXSP) and five-month (SPVXMP) S&P 500 VIX futures constant maturity indexes as proxies for them. They examine the hedging effectiveness of these indexes for five stock portfolios: 100% SPDR S&P 500 (SPY); 100% Vanguard Total Stock Market Index Fund (VTSMX); 80% VTSMX and 20% Vanguard Total Bond Market Index Fund (VBMFX); 60% VTSMX and 40% VBMFX; and, 40% VTSMX and 60% VBMFX. They also examine the hedging effectiveness of these indexes for three 2x-leveraged exchange-traded funds (ETF): ProShares Ultra S&P500 (SSO); ProShares Ultra QQQ (QLD); and, ProShares Ultra Dow30 (DDM). They compute optimal hedge ratios using consecutive (non-overlapping) 26-week lagged regressions of weekly total returns of each portfolio/ETF versus weekly returns of the hedging instrument. Using weekly data for all portfolio funds and VIX futures indexes since December 2005, and for leveraged ETFs since late July 2006, all through mid-April 2012, they find that: Keep Reading

Is planning for the worst case paramount in asset class allocation? In their May 2012 paper entitled “Minimax: Portfolio Choice Based on Pessimistic Decision Making”, Steffen Schaarschmidt and Peter Schanbacher examine the worst case scenario as a basis for portfolio optimization (Minimax strategy). Specifically, each year they run Monte Carlo simulations based on the last 250 trading days of returns to model all possible return scenarios for all possible long-only portfolio allocations. They then choose for the next year the portfolio allocation with the largest return for the worst case scenario. Using daily returns for the S&P 500 Index, Barclays Aggregate Bond Index, a Real Estate Investment Trust (REIT) index and the S&P GSCI Index, and the contemporaneous yield on 90-day Treasury bills as the risk-free rate, during 1990 through 2010, they find that: Keep Reading

How does consideration of return distribution tails (not just linear correlations) affect assessment of global equity diversification benefits? In their May 2012 paper entitled “Is the Potential for International Diversification Disappearing? A Dynamic Copula Approach”, Peter Christoffersen, Vihang Errunza, Kris Jacobs and Hugues Langlois examine the evolution of equity market diversification benefits based on a methodology that accommodates non-linearity in the relationship between return streams. They focus on differences between developed and emerging markets. Using weekly returns in U.S. dollar for 16 developed markets during January 1973 through mid-June 2009, 13 emerging markets during late January 1989 through July 2008 and 17 emerging markets during July 1995 through mid-June 2009, they find that: Keep Reading

Can reacting to short-term changes in asset return correlations improve efficient portfolio allocation? In their May 2012 paper entitled “The Role of Correlation Dynamics in Sector Allocation”, Elena Kalotychou, Sotiris Staikouras and Zhao Gang investigate the economic value of correlation timing in mean-variance optimal sector allocations. They test the usefulness of several correlation forecast methods by constructing dynamic, one-step-ahead (day, week or month) mean-variance optimal portfolios comprised of ten sectors in the Japanese, UK or U.S. equity markets (energy, basic materials, industrials, consumer goods, health care, consumer services, telecommunication, utilities, financials and technology). They use a static portfolio based on total-sample correlations as a benchmark. They use an initial subperiod (July 1996 through May 2005) to generate initial correlation forecasts and a later subperiod (Jun 2005 through May 2007) to implement recursive forecasts. They estimate sector index trading frictions for daily (monthly) portfolio rebalancing as approximately 0.07% (0.09%) for U.S., 0.30% (0.32%) for Japanese and 0.50% (0.52%) for UK sector indexes. Using daily prices for the ten sector indexes for each of the Nikkei 225, FTSE-All and S&P 500 during July 1996 through May 2007, along with corresponding interbank and U.S. Treasury bill yields as risk-free rates, they find that: Keep Reading

What is the big picture on stock return predictors? In their May 2012 paper entitled “The Supraview of Return Predictive Signals”, Jeremiah Green, John Hand and Frank Zhang examine aggregate characteristics of 333 signals for which formal research indicates power to predict stock returns. They categorize each signal as accounting-based (from firm financial statements, such as accruals), finance-based (directly or indirectly from stock prices, such as return momentum) or other-based (such as stock buybacks). They standardize across studies via annualization by multiplying daily, weekly, monthly and quarterly returns by 250, 52, 12 and 4, respectively. They compile equal-weighted returns and value-weighted returns separately. They focus on Sharpe ratio as a widely used metric for comparing investment performance. Using a database of predictive signals as published in top-tier U.S. accounting, finance and practitioner journals and as disseminated in academic working papers via the Social Science Research Network (SSRN) during 1970 through 2010, they conclude that: Keep Reading

Are there exchange-traded notes (ETN) based on S&P 500 Index implied volatility (VIX) futures, or combinations of such ETNs, that are attractive for absolute return and diversification? In the May 2012 version of their paper entitled “Volatility Exchange-Traded Notes: Curse or Cure?”, Carol Alexander and Dimitris Korovilas examine the behaviors of simple (first generation) and enhanced (second generation) ETNs constructed from VIX futures. They focus on: (1) roll return or yield, the loss (gain) of maintaining a position in VIX futures by continually rolling from a near to a far maturity contract when in contango (backwardation); and, (2) term structure convexity of VIX futures, the generally greater magnitude of roll return when rolling between contracts near to maturity versus between contracts far from maturity. To extend the sample period, they replicate recently available ETNs back to December 2005 using S&P constant-maturity VIX futures indexes and March 2004 using daily closes of VIX futures (debting respective annual ETN fees). Using daily closes for all VIX futures contracts, 30-day (VIX) and 93-day (VXV) S&P 500 implied volatility indexes as calculated by CBOE, S&P constant-maturity VIX futures indexes, one-month (VXX) and five-month (VXZ) constant-maturity VIX futures ETNs and two recently launched second-generation VIX futures ETNs (XVIX and XVZ) as available from late March 2004 through March 2012, they find that: Keep Reading

Is drawdown control a practical investment policy? In their February 2012 paper entitled “Optimal Portfolio Strategy to Control Maximum Drawdown: The Case of Risk-based Active Management with Dynamic Asset Allocation” (the National Association of Active Investment Managers’ 2012 Wagner Award third place winner), George Yang and Liang Zhong examine maximum percentage drawdown target as a criterion for active portfolio asset class allocation. They name the strategy Rolling Economic Drawdown-Controlled Optimal Portfolio Strategy (REDD-COPS), with REDD defined as maximum percentage drawdown of an asset’s value during a one-year rolling historical window. They simplify asset allocation calculations by assuming that the maximum drawdown target represents investor risk aversion. They test the active strategy on three asset class indexes: the S&P 500 Total Return Index, Barclays Capital 20+ Year U.S. Treasury Bond Index and Dow-Jones UBS Commodity Total Return Index, with the 3-month U.S. Treasury bill (T-bill) as the risk-free asset. Using daily, weekly and monthly data for these asset class proxies from as far back as January 1951 (but January 1991 for most tests) through June 2011, they find that: Keep Reading

How attractive can currency trading be after optimizing across several anomalies? In the November 2011 version of their paper entitled “Beyond the Carry Trade: Optimal Currency Portfolios”, Pedro Barroso and Pedro Santa-Clara examine the performance of utility-maximized currency strategies designed to exploit interest rate variables, momentum, long-term reversal, current account and real exchange rate during the floating exchange rate era. They also investigate whether such currency strategies are valuable to investors holding portfolios of equities and bonds. Their benchmark portfolio consists of $1 invested in the U.S. risk-free rate and $1 risked in a hedged carry trade (long all currencies yielding more than the U.S. dollar and short all others, with long and short sides equal and equal weighting across currencies within each side). They assume a power law utility function with constant level of risk aversion to specify optimal currency weightings. They perform out-of-sample testing based on inception-to-date regressions executed annually to specify optimal portfolios for the next year, commencing 240 months into the sample. Using spot and one-month forward exchange rates and data on current accounts and inflation as available for 27 developed economies during November 1960 through September 2010 (a total of 7,197 monthly currency returns involving 13 to 21 currencies per year), they find that: Keep Reading

What is the safest way to exploit asset price momentum? In his April 2012 paper entitled “Risk Premia Harvesting Through Momentum”  (the National Association of Active Investment Managers’ 2012 Wagner Award winner with different title), Gary Antonacci investigates systematic capture of upside volatility at the asset class level via a momentum/diversification/absolute return strategy that:

• Exploits momentum via long positions in winners, based on 12-month lagged total returns with no skip month, re-evaluated monthly.
• Maintains diversification by:
  • Using indexes rather than individual securities; and,
  • Holds the equally weighted winners from each the following pairs of competing indexes: gold versus long-term Treasury bonds; U.S. equities versus foreign equities; high yield bonds versus intermediate credit bonds; and equity real estate investment trusts (REIT) versus mortgage REITs.
• Mitigates risk by substituting Treasury bills (T-bills) for each pairwise winner that has not outperformed T-bills during the 12-month ranking interval.

Using monthly total returns for indexes constructed from targeted classes of equities, bonds, REITs and spot gold, along with contemporaneous 90-day Treasury bill yields, during January 1974 (or the earliest available) through December 2011, he finds that: Keep Reading

Has the free flow of capital since the 1990s weakened geographic (country-based) equity market diversification benefits? In their November 2011 paper entitled “Is World Stock Market Co-Movement Changing?”, Douglas Blackburn and N. K. Chidambaran examine recent trends in co-movement of stock markets worldwide. Their analysis employs principal component analysis to identify country, regional and world equity market return factors, allowing for structural break. They then quantify country commonality with the world factor via correlations. Using weekly return data for 23 developed country equity market indexes as available during 1981 through 2010 (30 years) and ten emerging country equity market indexes as available during 2000 through 2010, they find that: Keep Reading