What Works Best?

Of all the active investing/trading strategies investigated by research summarized in the blog, which ones that individual investors can practically implement work best? With reservations (because of all the uncertainties, statistical biases/criticisms and contradictory evidence to which the research is subject), here are some best guesses:

First, some precepts ranging from obvious to arguable:

• Asset prices repeatedly cross above and below their long-term trends.
• Driven by long-term (many centuries) real economic expansion and inflation, these long-term trends are generally up.
• Departures from trend derive from tendencies of financial markets, which are social systems, to overreact or underreact systematically to new information.
  • Confirmation bias helps sustain misreactions.
  • Misreactions to good/bad information may be asymmetrical in both degree and speed.
  • Misreaction may be path dependent, such that similar new information may lead to different misreactions under different market conditions. 
• Variations in prices are highly correlated for similar assets (which form asset classes), but substantially uncorrelated most of the time for different asset classes. 
• Individual investors can access asset classes (diversified across similar components) via exchange-traded fund (ETF) and mutual fund proxies.

Strategic diversification across asset classes harvests uncorrelated volatility via periodic rebalancing to some basic class allocation weights. Periodic rebalancing, independent of any ability to time asset classes, tends to move funds from asset classes that are above their long-term trends to those below their long-term trends.

While expanding the number of asset classes held and increasing the rebalancing frequency have theoretical (frictionless) benefits, there are real-life trade-offs between: (1) number of asset classes held and rebalancing frictions; and, (2) rebalancing frequency and rebalancing frictions.

There are analytical models for optimizing asset class allocation weights (such as Modern Portfolio Theory and derivative models). However, empirical results suggest that simple equal weighting is competitive, probably because the inputs to analytical methods involve unreliable estimates of future asset class returns, volatilities and mutual correlations.

For simplicity and friction avoidance, individuals might consider a strategic allocation involving perhaps five to ten equally weighted asset classes (via low-fee ETFs or mutual funds) and annual rebalancing. This largely passive approach requires little effort after setup.

Recent research relevant to strategic diversification includes:

• “Multi-class, Multi-factor Investing”
• “Global Multi-class Market Performance”
• “How Large University Endowments Allocate Investments”
• “Hard to Beat Equal Weighting?”
• “Mean-Variance Asset Allocation for Individual Investors”
• “Dependence of Optimal Allocations on Investment Horizon”
• “Net Benefits of Diversification”
• “When Rebalancing Works?”
• “Investment Factor Diversification”
• “Practitioner’s Perspective on Portfolio Risk Management Research”
• “Performance and Risk of Equity Strategy Indexes”
• “Overview of Risk-based Investment Allocations”
• “Volatility-based Equity Market Allocations”
• “Tests of Strategic Allocations Based on Risk Metrics”
• “Mean-Variance Optimizations Versus Equal Weight”
• “Mean-Variance Investing Basics”
• “Fundamentals of Portfolio Weights and Rebalancing”
• “Mean-Variance Optimization Versus Equal Weight”
• “How to Beat Equal Weight Asset Allocation?”
• “Diversifying Across Strategic Allocation Strategies?”
• “Combining Sharpe Ratio and Pairwise Correlation for Diversification”
• “Alternative Portfolio Efficiency Measures”
• “Asset Class Diversification Effectiveness Factors”
• “Adaptive Asset Allocation Policy”
• “University Endowment Performance: Strategic versus Tactical Allocation”
• “Translating Risk Strategies into Common Factors”
• “Harvesting Equity Market Premiums”
• “Asset Allocation Strategy Horse Race”
• “Alternative Global Equity Diversification Approaches”
• “Diversifying with Equity Volatility Exposure?”
• “Overview of Research on Asset Allocation in the Face of Disaster”
• “Liquidity in Asset Selection and Asset Class Allocation”
• “Hedges and Safe Havens Across Asset Classes”
• “An Era of Unstable Risk Premiums?”
• “Optimal Asset Class Allocations”

See the “Strategic Allocation” category for more.

For investors seeking an active edge, there is evidence supporting belief that the price paths followed by assets and asset classes in varying relative to their long-term trends are partly predictable, supporting belief in strategies based on intermediate-term momentum and longer-term reversion to value. These strategies may be complementary aspects of the same sloshing of capital from asset class to asset class, and from asset to asset within class. Because of misreaction dynamics and asymmetries, it appears that investors must be more nimble to exploit momentum than reversion to value, and to exploit overvaluation than undervaluation. Many technical trading rules derive from attempts to detect investor misreaction.

Individual investors can implement momentum and/or value allocation strategies for asset classes (again, via low-fee funds, keeping search and trading costs down). These strategies achieve strategic diversification to some degree via the number of (attractive) asset classes held at one time and, further, by varying the asset classes held over time. Relevant research includes:

• “Conservative Breadth Rule for Asset Class Momentum Crash Protection”
• “Simple Debt Class Mutual Fund Momentum Strategy”
• “Dual Momentum with Multi-market Breadth Crash Protection”
• “A Few Notes on Adaptive Asset Allocation”
• “Momentum in a Mean-variance Optimization Framework”
• “Simple Asset Class ETF Value Strategy (SACEMS)”
• “A Few Notes on Dual Momentum Investing“
• “Momentum-boosted Practical Approach to MPT”
• “Simplest Asset Class ETF Momentum Strategy?”
• “Tactical, Simplified, Long-only MPT with Momentum”
• “Mutual Fund Hot Hand Performance”
• “Asset Allocation Combining Momentum, Volatility, Correlation and Crash Protection”
• “Combining SMA Crash Protection and Momentum in Asset Allocation”
• “Melding Momentum, Diversification and Absolute Return”
• “Simple Asset Class ETF Momentum Strategy”
• “Industry/Asset Class Momentum Over the Long Run”
• “A Few Notes on The Ivy Portfolio: How to Invest Like the Top Endowments and Avoid Bear Markets”
• “Asset Class Momentum Strategy”
• “Asset Allocation Based on Trends Defined by Moving Averages”

Holding both momentum and value portfolios may be especially attractive due to their mutual diversification. Relevant research includes:

• “Carry Trade Across Futures Asset Classes”
• “Simple Asset Class ETF Value Strategy (SACEVS)”
• “SACEMS-SACEVS Diversification with Mutual Funds”
• “Carry and Trend Implications for Future Returns Across Asset Classes”
• “SACEVS-SACEMS for Value-Momentum Diversification”
• “Combining Value and Momentum Across Asset Classes”
• “Combined Value-Momentum Tactical Asset Class Allocation”

In summary, strategic diversification and momentum and value strategies applied at the asset class level via low-fee funds (especially with momentum and value in combination) may be among the best approaches for individual investors.

To reiterate, the above observations are guesses regarding the kind of practical investing/trading strategies that work best. Data snooping bias and defects in statistical assumptions are pervasive in research (see Avoiding Investment Strategy Flame-outs), and these shortcomings generally suborn overstatement of expected returns. Also, “best” is a function of individual goals and constraints.