# 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.

**November 5, 2019** - Momentum Investing, Strategic Allocation

The Simple Asset Class ETF Momentum Strategy (SACEMS) each month picks the one, two or three of nine asset class proxies with the highest cumulative total returns over a specified lookback interval. A subscriber proposed instead using the optimal intrinsic (time series or absolute) momentum lookback interval for each asset rather than a common lookback interval for all assets. SACEMS and the proposed approach represent different beliefs (which could both be somewhat true), as follows:

- Many investors adjust asset class allocations with some regularity, such that behaviors of classes are important and coordinated.
- Many investors switch between specific asset classes and cash with some regularity, such that each class may exhibit distinct times series behavior.

To investigate, we consider two ways to measure intrinsic momentum for each asset class proxy:

- Correlation between next-month return and average monthly return over the past one to 12 months. The lookback interval with the highest correlation has the strongest (linear) relationship between past and future returns and is optimal.
- Intrinsic momentum, measured as compound annual growth rate (CAGR) for a strategy that is in the asset (cash) when its total return over the past one to 12 months is positive (zero or negative). The lookback interval with the highest CAGR is optimal.

We use the two sets of optimal lookback intervals (optimization-in-depth) to calculate momentum for each asset class proxy as its average monthly return over its optimal lookback interval. We then compare performance statistics for these two alternatives to those for base SACEMS, focusing on: gross CAGR for several intervals; average gross annual return; standard deviation of annual returns; gross annual Sharpe ratio; and, gross maximum drawdown (MaxDD). Using monthly dividend-adjusted prices for SACEMS asset class proxies during February 2006 through September 2019, *we find that:*

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**October 31, 2019** - Bonds, Calendar Effects, Equity Premium, Strategic Allocation

Do quarterly allocation updates for the Best Value and Weighted versions of the “Simple Asset Class ETF Value Strategy” (SACEVS) work as well as monthly updates? These strategies allocate funds to the following asset class exchange-traded funds (ETF) according to valuations of term, credit and equity risk premiums, or to cash if no premiums are undervalued:

3-month Treasury bills (Cash)

iShares 20+ Year Treasury Bond (TLT)

iShares iBoxx $ Investment Grade Corporate Bond (LQD)

SPDR S&P 500 (SPY)

Changing from monthly to quarterly allocation updates does not sacrifice information about lagged quarterly S&P 500 Index earnings, but it does sacrifice currency of term and credit premiums. To assess alternatives, we compare cumulative performances and the following key metrics for quarterly and monthly allocation updates: gross compound annual growth rate (CAGR), gross maximum drawdown (MaxDD), annual gross returns and volatilities and annual gross Sharpe ratios. Using monthly dividend-adjusted closes for the above ETFs during September 2002 (earliest alignment of months and quarters) through September 2019, *we find that:*

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**August 30, 2019** - Bonds, Equity Premium, Momentum Investing, Strategic Allocation

“SACEMS-SACEVS for Value-Momentum Diversification” finds that the “Simple Asset Class ETF Value Strategy” (SACEVS) and the “Simple Asset Class ETF Momentum Strategy” (SACEMS) are mutually diversifying. Do longer samples available from “SACEVS Applied to Mutual Funds” and “SACEMS Applied to Mutual Funds” confirm this finding? To check, we look at the following three equal-weighted (50-50) combinations of the two strategies, rebalanced monthly:

- SACEVS Best Value paired with SACEMS Top 1 (aggressive value and aggressive momentum).
- SACEVS Best Value paired with SACEMS Equally Weighted (EW) Top 3 (aggressive value and diversified momentum).
- SACEVS Weighted paired with SACEMS EW Top 3 (diversified value and diversified momentum).

Using monthly gross returns for SACEVS and SACEMS mutual fund portfolios during September 1997 through July 2019, *we find that:*

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**August 23, 2019** - Bonds, Equity Premium, Strategic Allocation

“Simple Asset Class ETF Value Strategy” (SACEVS) finds that investors may be able to exploit relative valuation of the term risk premium, the credit (default) risk premium and the equity risk premium via exchange-traded funds (ETF). However, the backtesting period is limited by available histories for ETFs and for series used to estimate risk premiums. To construct a longer test, we make the following substitutions for potential holdings (selected for length of available samples):

To enable estimation of risk premiums over a longer history, we also substitute:

As with ETFs, we consider two alternatives for exploiting premium undervaluation: Best Value, which picks the most undervalued premium; and, Weighted, which weights all undervalued premiums according to degree of undervaluation. Based on the assets considered, the principal benchmark is a monthly rebalanced portfolio of 60% VFINX and 40% VFIIX. Using monthly risk premium calculation data during March 1934 through July 2019 (limited by availability of T-bill data), and monthly dividend-adjusted closing prices for the three asset class mutual funds during June 1980 through July 2019 (39 years, limited by VFIIX), *we find that:*

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**July 26, 2019** - Momentum Investing, Strategic Allocation

How lucky would a asset class picker with no skill have to be to match the performance of the Simple Asset Class Momentum Strategy (SACEMS), which each month picks winners from a set of eight exchange-traded funds (ETF) plus cash based on total returns over a specified lookback interval. To investigate, we run 1,000 trials of a “strategy” that each month allocates funds to one, the equally weighted two or the equally weighted three of these nine assets picked at random. We focus on gross compound annual growth rate (CAGR) and gross maximum drawdown (MaxDD) as key performance statistics. Using monthly total (dividend-adjusted) returns and for the specified assets during February 2006 (limited by DBC) through June 2019, *we find that:*

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**July 22, 2019** - Momentum Investing, Strategic Allocation

A subscriber inquired whether a longer test of the “Simple Asset Class ETF Momentum Strategy” (SACEMS) is feasible using mutual funds rather than exchange-traded funds (ETF) as asset class proxies. To investigate, we consider the following set of mutual funds (partly adapted from the paper summarized in “Asset Allocation Combining Momentum, Volatility, Correlation and Crash Protection”):

- Vanguard Total Stock Market Index Investor Shares (VTSMX)
- Vanguard Small Capitalization Index Investor Shares (NAESX)
- Fidelity Diversified International (FDIVX)
- Vanguard Long-Term Treasury Investor Shares (VUSTX)
- Fidelity New Markets Income Fund (FNMIX)
- Vanguard REIT Index Investor Shares (VGSIX)
- First Eagle Gold A (SGGDX)
- Oppenheimer Commodity Strategy Total Return A (QRAAX) until discontinuation in mid-2016, and PIMCO CommoditiesPLUS Strategy (PCPSX) thereafter
- 3-month U.S. Treasury bills (Cash)

We rank mutual funds based on total (dividend-adjusted) returns over past (lookback) intervals of one to 12 months. We consider portfolios of past mutual fund winners based on Top 1 and on equally weighted (EW) Top 2 through Top 5. We consider as benchmarks: an equally weighted portfolio of all mutual funds, rebalanced monthly (EW All); buying and holding VTSMX; and, holding VTSMX when the S&P 500 Index is above its 10-month simple moving average (SMA10) and Cash when the index is below its SMA10 (VTSMX:SMA10). Using monthly dividend-adjusted closing prices for the above mutual funds and the yield for Cash during March 1997 through June 2019, *we find that:* Keep Reading

**July 19, 2019** - Momentum Investing, Strategic Allocation

The Simple Asset Class ETF Momentum Strategy (SACEMS) each month picks winners based on total return over a specified ranking (lookback) interval from 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 2000 Index (IWM)
- SPDR S&P 500 (SPY)
- iShares Barclays 20+ Year Treasury Bond (TLT)
- Vanguard REIT ETF (VNQ)
- 3-month Treasury bills (Cash)

Based on findings in “SACEMS Portfolio-Asset Addition Testing”, a subscriber proposed adding iShares JPMorgan Emerging Market Bond Fund (EMB) to this set. To investigate, we revisit relevant analyses and conduct robustness tests, with focus on the equal-weighted (EW) Top 3 SACEMS portfolio. Using monthly dividend-adjusted closing prices for asset class proxies and the yield for Cash during February 2006 (when all ETFs in the baseline universe are first available) through June 2019, *we find that:* Keep Reading

**July 11, 2019** - Strategic Allocation

Can investors beat a typical active U.S. equity mutual fund via a small portfolio of periodically re-weighted equity exchange-traded funds (ETF)? In their February 2019 paper entitled “Are Passive Funds Really Superior Investments: An Investor Perspective”, flagged by a subscriber, Edwin Elton, Martin Gruber and Andre de Souza:

- Determine via cluster analysis a small set of ETFs that captures most of the variation in 69 broad U.S. equity indexes.
- Explore use of this set to mimic past performances of many active U.S. equity mutual funds via 24-month linear regressions with ETF coefficients scaled to sum to one.
- Compare next-year (close of first trading day of the year after coefficient calculation to close of first trading day next year) returns of mimicking ETF portfolios and active mutual fund counterparts.

Their target set of 883 active U.S. equity mutual funds are those with at least: three years of data as of January 2003; $15 million in assets; and, 90% of assets allocated broadly to stocks. Using monthly returns for 69 U.S. equity indexes, the small set of passive equity ETFs that capture variation in these indexes and 883 active U.S. equity mutual funds during January 2003 through December 2018, *they find that:*

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**June 24, 2019** - Bonds, Equity Options, Gold, Momentum Investing, Strategic Allocation

What steps should investors consider to mitigate impact of inevitable large U.S. stock market corrections? In their May 2019 paper entitled “The Best of Strategies for the Worst of Times: Can Portfolios be Crisis Proofed?”, Campbell Harvey, Edward Hoyle, Sandy Rattray, Matthew Sargaison, Dan Taylor and Otto Van Hemert compare performances of an array of defensive strategies with focus on the eight worst drawdowns (deeper than -15%) and three NBER recessions during 1985 through 2018, including:

- Rolling near S&P 500 Index put options, measured via the CBOE S&P 500 PutWrite Index.
- Credit protection portfolio that is each day long (short) beta-adjusted returns of duration-matched U.S. Treasury futures (BofAML US Corp Master Total Return Index), scaled retrospectively to 10% full-sample volatility.
- 10-year U.S. Treasury notes (T-notes).
- Gold futures.
- Multi-class time-series (intrinsic or absolute) momentum portfolios applied to 50 futures contract series and reformed monthly, with:
- Momentum measured for 1-month, 3-month and 12-month lookback intervals.
- Risk adjustment by dividing momentum score by the standard deviation of security returns.
- Risk allocations of 25% to currencies, 25% to equity indexes, 25% to bonds and 8.3% to each of agricultural products, energies and metals. Within each group, markets have equal risk allocations.
- Overall scaling retrospectively to 10% full-sample volatility.
- With or without long equity positions.

- Beta-neutral factor portfolios that are each day long (short) stocks of the highest (lowest) quality large-capitalization and mid-capitalization U.S. firms, based on profitability, growth, balance sheet safety and/or payout ratios.

They further test crash protection of varying allocations to the S&P 500 Index and a daily reformed hedge consisting of equal weights to: (1) a 3-month time series momentum component with no long equity positions and 0.7% annual trading frictions; and, (2) a quality factor component with 1.5% annual trading frictions. For this test, they scale retrospectively to 15% full-sample volatility. Throughout the paper, they assume cost of leverage is the risk-free rate. Using daily returns for the S&P 500 Index and inputs for the specified defensive strategies during 1985 through 2018, *they find that:*

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**June 11, 2019** - Strategic Allocation

Considering taxes, in what order should U.S. retirees consume different sources of retirement savings/income? In their August 2018 paper entitled “Constructing Tax Efficient Withdrawal Strategies for Retirees with Traditional 401(k)/IRAs, Roth 401(k)/IRAs, and Taxable Accounts”, James DiLellio and Daniel Ostrov describe and illustrate an algorithm that computes individualized tax-efficient consumption for U.S. retirees of:

- Tax-deferred retirement accounts [Traditional IRA/401(k)].
- Post-tax retirement accounts [Roth IRA/Roth 401(k)].
- Other taxable retirement accounts.
- Other sources of money subject to income tax, including: earned income, some pensions, annuities bought with pre-tax money, earnings from annuities bought with post-tax money and sometimes Social Security benefits.
- Other sources of money that do not affect tax rates of retirement accounts, such as: tax-free gifts, Health Savings Accounts, some pensions, principal from annuities bought with post-tax money and sometimes Social Security benefits.

Their model adapts to individual retiree circumstances and accommodates typical changes in tax policies (changes in marginal rates and number of brackets). For tractability, they make simplifying assumptions. The principal simplification is that return on stocks, stock dividend yield, inflation rate, tax brackets and rates, other income sources and consumption rates are known each year (not random variables). When the goal is to optimize a bequest, inputs also include year of retiree death, marginal tax rate of the heir and rate the heir consumes inherited retirement accounts. They do not attempt to determine the optimal mix of stocks and bonds/cash within retirement accounts (their deterministic model would prefer all stocks). Using illustrations of algorithm outputs based on varying input assumptions, *they find that:* Keep Reading