# 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.

**August 1, 2017** - Bonds, Equity Premium, Strategic Allocation

A subscriber asked how the “Simple Asset Class ETF Value Strategy” (SACEVS) performs when interest rates rise. This strategy seeks to exploit relative valuation of the term risk premium, the credit (default) risk premium and the equity risk premium via exchange-traded funds (ETF). To investigate, because the sample period available for mutual funds is much longer than that available for ETFs, we use instead data from “SACEVS Applied to Mutual Funds”. Specifically, each month we reform a Best Value portfolio (picking the asset associated with the most undervalued premium, or cash if no premiums are undervalued) and a Weighted portfolio (weighting assets associated with all undervalued premiums according to degree of undervaluation, or cash if no premiums are undervalued) using the following four assets:

The benchmark is a monthly rebalanced portfolio of 60% stocks and 40% U.S. Treasuries (60-40 VWUSX-VFIIX). We use the T-bill yield as the short-term interest rate (SR) and the 10-year Constant Maturity U.S. Treasury note (T-note) yield as the long-term interest rate (LR). We say that each rate rises or falls when the associated average monthly yield increases or decreases during the SACEVS holding month. Using monthly risk premium estimates, SR and LR, and Best Value and Weighted returns during June 1980 through June 2017 (444 months), *we find that:*

Keep Reading

**July 25, 2017** - Momentum Investing, Strategic Allocation

A subscriber asked for augmentation of “SACEMS at Weekly and Biweekly Frequencies” to determine whether bimonthly (every two months) measurement of asset class momentum works better than monthly measurement as used in “Simple Asset Class ETF Momentum Strategy” (SACEMS). To investigate, we apply a bimonthly strategy 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 2000 Index (IWM)

SPDR S&P 500 (SPY)

iShares Barclays 20+ Year Treasury Bond (TLT)

Vanguard REIT ETF (VNQ)

3-month Treasury bills (Cash)

We use the same lookback interval as for basic SACEMS and consider portfolios of past ETF winners based on Top 1 and on equally weighted (EW) Top 2 and Top 3. Since a bimonthly lookback interval uses every other set of monthly signals, we consider two variations: (1) start at the end of July 2006, when signals are first available for the entire set of ETFs, and end with May 2017; and, (2) start at the end of August 2006 and end with June 2017. We consider as benchmarks an equally weighted portfolio of all ETFs, rebalanced monthly (EW All) and basic monthly SACEMS. We focus on gross compound annual growth rates (CAGR), annual returns and maximum drawdowns (MaxDD) as performance metrics. Using monthly dividend-adjusted closing prices for the asset class proxies and the yield for Cash during February 2006 (when all ETFs are first available) through June 2017 (137 months), *we find that:* Keep Reading

**July 12, 2017** - Big Ideas, Strategic Allocation

Michael Covel prefaces the 2017 Fifth Edition of his book, *Trend Following: How to Make a Fortune in Bull, Bear, and Black Swan Markets*, by stating that: “The 233,092 words in this book are the result of my near 20-year *hazardous journey* for the truth about this trading called *trend following*. …Trend following…aims to capture the majority of a connected market trend up or down for outsize profit. It is designed for potential gain in all major asset classes–stocks, bonds, metals, currencies, and hundreds of other commodities. …if you want outside-the-the-box *different*, the truth of how out-sized returns are made without any fundamental predictions or forecasts, this is it. And if you want the honest data-driven proof, I expect my *digging* will give everyone the necessary confidence to break their *comfort* addiction to the box they already know and go take a swing at making a fortune…” Based on his experience as a trader/portfolio manager and the body of trend following research, *he concludes that:* Keep Reading

**July 7, 2017** - Momentum Investing, Strategic Allocation

What is the most effective way to hedge against equity market crashes? In their June 2017 paper entitled “The Best Strategies for the Worst Crises”, Michael Cook, Edward Hoyle, Matthew Sargaison, Dan Taylor and Otto Van Hemert examine active and passive strategies with potential to generate positive returns during the worst crises. They test these strategies across the seven S&P 500 Index drawdowns of more than 15% during 1985 through 2016. They focus on two active strategies:

- Time-series (intrinsic or absolute) momentum long-short portfolio comprised of 50 liquid futures and forwards series spanning currencies, equity indexes, bonds, agricultural products, energy and metals. They consider return lookback intervals of 1, 3 and 12 months. They apply risk adjustments, risk allocations by class and finally a scale factor targeting 10% annualized portfolio volatility. They consider three extensions of the strategy that preclude or restrict positive exposure to equity market beta.
- Quality factor long-short portfolios comprised of intermediate and large capitalization U.S. stocks. These portfolios ares long (short) the highest-ranked (lowest-ranked) stocks, as selected based on one of 18 metrics representing profitability, growth in profitability, safety and payout. Rankings are risk-adjusted and portfolios are equity market beta-neutral. They again apply a scale factor targeting 10% annualized portfolio volatility. They also consider several composite factor portfolios by averaging individual factor rankings and weighting for dollar neutrality, beta neutrality, sector neutrality and/or volatility balancing.

Using daily data for all indicated assets during 1985 through 2016, *they find that:* Keep Reading

**July 3, 2017** - Momentum Investing, Strategic Allocation

Subscribers asked whether weekly or biweekly (every two weeks) measurement of asset class momentum works better than monthly measurement as used in “Simple Asset Class ETF Momentum Strategy” (SACEMS), hypothesizing that the faster frequencies would respond more quickly to market turns. To investigate, we compare simple weekly, biweekly and monthly strategies 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 2000 Index (IWM)

SPDR S&P 500 (SPY)

iShares Barclays 20+ Year Treasury Bond (TLT)

Vanguard REIT ETF (VNQ)

3-month Treasury bills (Cash)

We use comparable lookback intervals, though they differ slightly due to mismatches between ends of weeks and ends of months. We consider portfolios of past ETF winners based on Top 1 and on equally weighted (EW) Top 2 and Top 3. We consider as benchmarks an equally weighted portfolio of all ETFs, rebalanced at the measurement frequency (EW All) and basic SACEMS at a monthly frequency. We focus on gross compound annual growth rates (CAGR), annual returns and maximum drawdowns (MaxDD) as performance metrics. Using weekly dividend-adjusted closing prices for the asset class proxies and the yield for Cash during February 2006 (when all ETFs are first available) through May 2017 (136 months), *we find that:* Keep Reading

**June 26, 2017** - Fundamental Valuation, Strategic Allocation

Is there a way to enhance the ability of the cyclically-adjusted price-to-earnings ratio (P/E10 or CAPE) to predict U.S. stock market returns by incorporating real interest rates? In their June 2017 paper entitled “Improving U.S. Stock Return Forecasts: A ‘Fair-Value’ Cape Approach”, Joseph Davis, Roger Aliaga-Diaz, Harshdeep Ahluwalia and Ravi Tolani introduce “fair-value” CAPE that accounts for a dynamic, positive relationship between real 10-year U.S. Treasury note (T-note) yield (cost of capital) and real earnings yield (return on equity). They hypothesize that a lower real T-note yield should imply a lower earnings yield and thus a higher fair-value CAPE. Their use of fair-value CAPE to forecast stock market return involves:

- Each month, execute a multiple vector autoregression of the logarithms of the following five variables separately for each of the last 12 months: (1) inverse of CAPE; (2) expected real T-note yield based on a 10-year U.S. inflation forecast; (3) U.S. inflation; (4) realized S&P 500 Index price volatility over the last 12 months; and, (5) realized volatility of changes in real T-note yield over the last 12 months. Their 10-year inflation forecast is the average of 120 monthly forecasts generated via autoregression of the U.S. consumer price index over a 30-year rolling window.
- Each month, forecast 10-year stock market return (see the chart below) by summing: (1) percentage change in CAPE from the preceding vector autoregression; (2) constant earnings growth equal to its long-term average; and, (3) dividend yield calculated as earnings yield times the historical payout ratio.

They then compare out-of-sample forecasts of 10-year U.S. stock market returns for 1960 through 2016 and 1985 through 2016 generated by fair-value CAPE and two conventional CAPEs: Shiller CAPE based on Generally Accepted Accounting Principles (GAAP); and, Siegel CAPE based on National Income and Product Accounts (NIPA) earnings. Using Shiller’s data and NIPA earnings during 1950 through 2016, *they find that:* Keep Reading

**June 19, 2017** - Strategic Allocation

What is the performance of the global multi-class market portfolio? In their June 2017 paper entitled “Historical Returns of the Market Portfolio”, Ronald Doeswijk, Trevin Lam and Laurens Swinkels estimate returns to a capitalization-weighted multi-class global market portfolio (GMP) during 1960 through 2015 in U.S. dollars. GMP encompasses all readily investable assets, allocated to four broad classes: equities, government bonds, corporate (nongovernment) bonds and real estate. They estimate nominal, real (relative to U.S. consumer inflation) and excess (relative to the risk-free rate) return and risk characteristics of GMP and its component asset classes over the full sample period, and during expansion/contraction and inflationary/disinflationary subperiods. They also compare GMP performance statistics to those for the following three heuristic (simple mean reversion) portfolios rebalanced annually to fixed weights:

- Equal-weighted (EW).
- Rank-weighted (RW), which assigns weights 40%, 30%, 20% and 10%, respectively, to equities, government bonds, corporate bonds and real estate.
- 50/50, which holds 50% equities and 50% government bonds.

Using annual data for the asset classes constructed according to Appendix A of the paper, annual yields for 3-month U.S. Treasury bills (T-bills) as the risk-free rate and annual U.S. consumer inflation rates, from the end of 1959 through 2015, *they find that:* Keep Reading

**June 12, 2017** - Equity Premium, Strategic Allocation, Volatility Effects

Can investors predict the return of a stock from its relationship with the dispersion of returns across all stocks? In their May 2017 paper entitled “Building Efficient Portfolios Sensitive to Market Volatility”, Wei Liu, James Kolari and Jianhua Huang examine a 2-factor model which predicts the return on a stock based on its sensitivity to (1) the value-weighted stock market return (beta risk) and (2) the standard deviation of value-weighted returns for all stocks (zeta risk). They first each month estimate zeta for each stock via regressions of daily data over the past year. They then rank stocks by zeta into quantile portfolios and calculate next-month equal-weighted returns across these portfolios and various long-short combinations of these portfolios (hedge portfolios) to measure dependence of future returns on zeta. Finally, they generate performance data for aggregate zeta risk portfolios by adding value-weighted market index returns to returns for each of the long-short zeta-sorted portfolios. Using daily and monthly returns for a broad sample of U.S. stocks in the top 90% of market capitalizations for that year, monthly equity market returns and monthly U.S. Treasury bill yields as the risk-free rate during January 1965 through December 2015, *they find that:* Keep Reading

**June 5, 2017** - Commodity Futures, Currency Trading, Strategic Allocation, Value Premium

Does a carry trade derived from roll yields of futures/forward contracts work within asset classes (undiversified) and across asset classes (iversified)? In his May 2017 paper entitled “Optimising Cross-Asset Carry”, Nick Baltas explores the profitability of cross-sectional (relative) and time-series (absolute) carry strategies within and across futures/forward markets for currencies, stock indexes, commodities and government bonds. He posits that contracts in backwardation (contango) present a positive (negative) roll yield and should generally be overweighted (underweighted) in a carry portfolio. He considers three types of carry portfolios, each reformed monthly:

- Cross-sectional (XS) or Relative – Rank all assets within a class by strength of carry, demean the rankings such that half are positive and half are negative and then assign weights proportional to demeaned ranks to create a balanced long-short portfolio. Combine asset classes by applying inverse volatility weights (based on 100-day rolling windows of returns) to each class portfolio.
- Times-series (TS) or Absolute – Go long (short) each asset within a class that is in backwardation (contango), such that the class may be net long or short. Combine asset classes in the same way as XS.
- Optimized (OPT) – Apply both relative strength and sign of carry to determine gross magnitude and direction (long or short) of positions for all assets, and further apply asset volatilities and correlations (based on 100-day rolling windows of returns) to optimize return/risk allocations.

Using daily data for 52 futures series (20 commodities, eight 10-year government bonds, nine currency exchange rates versus the U.S. dollar and 15 country stock indexes) during January 1990 through January 2016, *he finds that:* Keep Reading

**May 26, 2017** - Strategic Allocation, Volatility Effects

What modifications must investors make to minimum variance portfolios to make them more attractive than equal weighting? In their April 2017 paper entitled “Asset Allocation with Correlation: A Composite Trade-Off”, Rachael Carroll, Thomas Conlon, John Cotter and Enrique Salvador assess conditions under which a minimum variance portfolio (requiring only estimates of asset covariances) beats an equally weighted portfolio. In particular, they test minimum variance portfolios that:

- Employ one of three ways (one constant and two dynamic) to estimate future asset return correlations.
- Consider a range of correlation forecasting horizons.
- Do and do not have shorting restrictions.
- Limit turnover by rebalancing only when: (1) any weight drifts outside a fixed percentage band; or, (2) any asset drifts outside a no-trade range based on its volatility, such that each asset has the same probability of triggering (allowing riskier assets more latitude).
- Have rebalancing frictions of either 0.2% or 0.5% of traded value.

These variations enable analyses of trade-offs among parameter estimation error, correlation forecasting horizon, turnover and rebalancing frictions. Their key portfolio performance metrics are volatility, Sharpe ratio and turnover. They consider seven asset universes for forming minimum variance portfolios: 10, 30 or 48 U.S. industry portfolios during January 1970 through December 2013; 20 portfolios of U.S. stocks sorted by size and book-to-market ratio during January 1970 through December 2013; stock indexes for nine developed countries during January 1980 through December 2013; the 30 stocks in the Dow Jones Industrial Average during January 2003 through December 2012; and, the 197 stocks continuously listed in the S&P 500 Index during January 1996 through December 2012. Using daily returns in excess of the risk-free rate for the assets in these universes, *they find that:* Keep Reading