There is a cool new website that tracks the performance of well-known tactical strategies. AllocateSmartly has collected an extensive list of strategies from well-known hedge fund managers like Ray Dalio along with several other portfolio managers and financial bloggers. The backtests for these strategies use a very detailed and comprehensive method that is both conservative and realistic. Where possible, the author uses tradeable assets rather than indices and factors in transaction costs along with careful treatment of dividends. The current allocations and performance are tracked in real-time which allows investors to be able to realistically trade these portfolios. Curiously the best performing model tracked on the website this year is the Minimum Correlation Algorithm from CSSA which says a lot about the importance of diversification in 2016 versus momentum and managing risk via trend-following/time-series momentum. In fact, if you dig deeper you will notice that most of the best performers have a structural or dynamic diversification element. The worst performers have been the most concentrated and oriented toward identifying the best performers. As the website correctly points out- the diversification oriented strategies tend to do well during normal market conditions but ultimately the dynamic and more tactical strategies outperform during bear markets. Over longer backtest periods, the more truly tactical performers had better long-term performance. Different market regimes will reward different approaches depending on how predictable and interrelated the markets happen to be that year. An umbrella is great for a rain storm but less than ideal for a sunny day. That is why it is important to understand the strategies you are following and why you are investing in them rather than blindly chase performance. While many quant developers and investors chase the best looking equity curves it is important to consider two primary factors: 1) the utility curve that works best for any one individual is a very personal choice (ie risk/reward and tracking error) 2) you need to choose a set of assumptions for capital markets either going forward or over the long-term: will returns, correlations or volatility be predictable and if so which will be the most predictable and why.
On a side note, I was informed that the very popular “A Simple Tactical Asset Allocation Strategy with Percentile Channels” by CSSA is also being added to the AllocateSmartly website very soon. This is a tactical and structural diversification hybrid that provides balanced factor risk with the ability to de-risk during market downturns. While it lacks the higher returns of more momentum-oriented or equity-centric strategies it provides a steady and low-risk profile across market conditions.
Disclosure: The author(s) principally responsible for the preparation of this material are expressing their own opinions and viewpoints, which are subject to change without notice and may differ from the view or opinions of others at BSAM or its affiliates. Any conclusions presented are speculative and are not intended to predict the future of any specific investment strategy. This material is based on publicly available data as of the publication date and largely dependent on third party research and information which we do not independently verify. We make no representation or warranty with respect to the accuracy or completeness of this material. One cannot use any graphs or charts, by themselves, to make an informed investment decision. Estimates of future performance are based on assumptions that may not be realized and actual events may differ from events assumed. BSAM is not acting as a fiduciary in presenting this material. Benchmark indices are presented or discussed for illustrative purposes only and do not account for deduction of fees and expenses incurred by investors.
The strategies discussed in this material may not be suitable for all investors. We urge you to talk with your investment adviser prior to making any investment decisions. Information taken from Minimum Correlation Algorithm strategy article is publicly available and used by a third party to generate the strategies and signals provided on AllocateSmartly.com. We have not reviewed and do not represent this information as accurately interpreted or utilized.
I recently read “Adaptive Asset Allocation” ( link to the book) by Butler, Philbrick and Gordillo of ReSolve Asset Management. The book is the culmination of research developed over the years by the ReSolve team towards the next generation approach of dynamic asset allocation. The core principles of this approach are the ability to “go anywhere” and adapt to changes in the economic environment in the quest for greater risk-adjusted returns. (CSSA readers may recall a post we did a while back on adaptive asset allocation, if not it is worth a refresher along with one of the original whitepapers on AAA) The book is extremely well-written, and the chapters are easy to read- developing the story persuasively from cover to cover.
This book is not a dense quantitative tome , but rather a summary of a coherent and rigorously developed investment philosophy that is carefully built around academic research and concepts. To that extent, Adaptive Asset Allocation is a true “tour de force” and a key contribution to the field of asset allocation theory. Without this background, it is impossible to frame ideas properly within any trading system or tactical asset allocation model. It is far too easy to get confused over the wide range of possible approaches to portfolio management: should you use momentum? should you seek to minimize risk? should you use long-term or short-term estimates? should you include or exclude certain asset classes? what time frame should you trade on? Ultimately the answers to these questions are driven by having a framework that neatly incorporates what input assumptions that you are confident in making versus those that you don’t know anything about. The book really helps to address these key issues in the development of trading models/systems. Adaptive Asset Allocation also neatly ties in the natural link between an active asset allocation approach and financial planning. Much of this is both theoretical and also based on their experience working as financial advisors with wealthy clients. The authors show that managing “volatility gremlins” with a portfolio management approach that is specifically designed to manage volatility itself is critical for investors in retirement. Adaptive Asset Allocation is not just an investment philosophy or a quantitative approach, but rather the book proves that it is a coherent and comprehensive solution for wealth management.
Who should read the book?: If you are a short-term trader that is looking for trading system ideas this probably isn’t for you. But if you are an investor, a portfolio manager, or a trader interested in longer frequency models, this is an essential book that will help to develop and crystallize your thinking towards asset allocation.
We wrote a more quant-friendly article on volatility futures and their impact on S&P500 performance recently on our blog for Blue Sky Asset Management. We will be dedicating a section of the blog specifically for more technical articles. This is the first of many that we have planned in the coming months so stay tuned for more geeky quant goodness!
A tactical approach based on momentum would require that investors reduce their risk recently as volatility rose and trends deteriorated. Obviously no one knows what will happen going forward (ie is this a bull market or a correction) but from a purely qualitative perspective, the economic environment warrants more caution than usual. In general it is my belief that the global quantitative reflation is nearing the end of its course and overall efficacy. Like the last five episodes of “Breaking Bad”, investors can expect a wild ride with many different twists and turns. Read our recent post here.
This post is a follow up to part one: Defense is the Best Offense
Sometimes the decisions we make in everyday life are good case studies for making effective investing decisions. My wife and I recently traveled to Santorini Island in Greece where we stayed in the village of Imerovigli. During our trip we planned to hike to Oia – which has the nicest views on the island. The hike would take roughly two hours through a couple small towns and some isolated mountainous terrain beside the Aegean Sea. click here to read the full story
Check out our latest post on Greece and how to trade it here. We believe that a quantitative approach is the best way to trade macro events. Using discretionary calls becomes increasingly difficult as the complexity of the situation increases. A good post on the perils of discretionary macro investing by Barry Ritholz can be found here.
A note to readers: I have posted some interesting material the last few weeks on Blue Sky Asset Management (BSAM) that may be of interest. This includes our monthly commentaries on current market observations and also a whitepaper series on Dynamic Asset Allocation that is definitely worth reading. I also recently posted a new blog article on the site as well: Defense is the Best Offense Readers should keep an eye out on the website as we plan to roll out some “geekier” research papers and interesting current market analytics in the future.
I have spent many years toiling with creating different asset allocation methodologies including the application of traditional and non-traditional portfolio optimization. Given the recent flare of articles on this topic in the blogosphere, I felt it was worthwhile to share my two cents. Applying optimization to a tactical approach is a topic that readers may already be familiar with, I recently posted an article on the subject on my LinkedIn : Think MPT Doesn’t Work? You Are Probably Using it the Wrong Way . Wouter Keller of Flex Capital, Adam Butler of BPG, and Ilya Kipnis of Quantstratrader wrote a great paper that was referenced in the post that readers are encouraged to take a look at; Momentum and Markowitz; A Golden Combination. They show that using the MPT algorithm in a dynamic context with shorter-term data helps to capture the momentum effect as well as producing diversified portfolios with good risk-adjusted returns. This paper is in many ways a very important contribution to a stream of research and practitioner debate that is at times imbalanced and one-sided— and without good logical reasons. MPT happens to be widely and roundly criticized in the industry for perceived algorithm-specific flaws and research that shows poor out-of-sample performance. Of course, this is primarily because it is used the wrong way–at intermediate or longer time horizons that are ill-suited to the approach. It is also important to keep in mind that industry heavyweights such as AQR and Goldman Sachs have used variants of a dynamic MPT approach to build sophisticated portfolios that have performed very well for decades.
Some other related articles on the same topic that are quite interesting include The Universal Investment Strategy by Frank Grossman of Logical Invest, and Momentum and Diversification by Andrew Gogerty of Newfound Research – 3rd Place winner of the prestigious NAAIM Wagner Award. The methodology in these two articles for optimization is nearly identical. They both find maximum Sharpe portfolios by using brute force to combine equity curves with a constrained set of choices into a portfolio instead of using MPT. It is important to understand that both MPT and these approaches are essentially interchangeable for the most part (MPT finds the brute force optimal solution mathematically). Grossman uses a variant on the objective function with a risk-aversion parameter. Newfound introduces the twist of allowing for different rebalancing windows in the lookback window which is more similar to a dynamic programming approach. In both cases, I wanted to clarify to readers that finding the sharpe ratio by combining equity curves (assuming daily rebalance) is identical to using the calculated correlation/volatility and return to compute sharpe optimal portfolios- so there is no escaping “estimation error” it is just implicit as opposed to explicit.
Wes Gray of Alpha Architect is always a good source of research and demonstrates the more traditional use of MPT (not the tactical) in asset allocation in his post; Beware of Geeks Bearing Formulas. Unfortunately, this post is not comparing apples to apples since the MPT lookback parameters are longer-term than the simple tactical benchmarks being compared. As a consequence this post happens to be biased against the use of MPT in a dynamic format which is common within the industry and in my opinion a bit unfair since there is more good to work with than bad. It just happens to be the case that using MPT in a tactical format comes with a set of unique complexities that do not plague simpler methods- these include higher turnover, concentrated portfolios and greater sensitivity to estimation error. The higher level of estimation error occurs for several reasons. One is greater dimensionality since there are many more inputs to estimate. The other is that in MPT the magnitude of returns dictate weights as well as the ranks of returns—in contrast a basic momentum approach only pays attention to rank. This puts greater pressure on return estimation in MPT versus a simple momentum approach. Another issue is the integration of noisy/random correlations which interfere with errors in return estimates. Adding correlations is important for stressing diversification but only to the extent that they are not highly error-prone. Using MPT for allocating across investment strategies rather than asset allocation is even more challenging since strategies have far more complex inputs to estimate, and some inputs cannot be estimated quantitatively. On the positive side, using MPT in a tactical approach carries much less room for data mining bias than building a simple tactical system using rules. This is especially true if the system builder is free to vary multiple parameters and may also choose their investment universe through repeated testing. Using one algorithm that is mathematically compact like MPT with one lookback parameter is far less subject to these insidious data mining problems.
I think the most important takeaway from the debate in the industry is that many algorithms, trading methods, or indicators are often unfairly discarded through improper or unsuitable analysis (or use) rather than for true deficiencies. The skilled cook can take a few mediocre or exotic ingredients and create a masterpiece while less knowledgeable cooks can find the same box of ingredients to be wholly deficient for creating a suitable meal. There are plenty of examples of people that have been successful even with the ultimate black-box machine-learning approach–it is a hazardous path much like climbing Mount Everest but apparently there are some good climbers out there (see Renaissance Technologies). Of course in good quantitative system design as in cooking, using great simple ingredients makes it easy to create a great meal without a lot of manipulation or effort. Pushing the edges by exploring the more exotic applications creates greater risk of failure but also greater opportunity- and that is a risk worth taking in highly competitive markets. You just need to have a good understanding of where to draw the line. To that extent, I guess the decision to incorporate MPT within tactical asset allocation is ironically a matter concerning utility curves……..