Strategic Allocation

Does using after-tax, rather than pre-tax, returns make a big difference in allocating assets based on mean-variance optimization? In their June 2014 paper entitled “What Would Yale Do If It Were Taxable?” Patrick Geddes, Lisa Goldberg and Stephen Bianchi illustrate a three-step approach for adapting the Yale Endowment for investors obligated to pay U.S. taxes:

1. Reverse engineer Yale Endowment allocations by applying covariances of matched benchmark indexes to derive implied pre-tax asset class returns.
2. Apply assumptions about taxes to convert the pre-tax returns to after-tax returns.
3. Apply mean-variance optimization to after-tax returns to calculate optimal allocations based on after-tax returns.

The asset classes addressed are: absolute return (hedge funds), equity (U.S. and global combined), bonds, natural resources, real estate, private equity and cash. For estimating tax impacts, the authors assume: returns from bonds and cash are ordinary income; there are distinct tax obligations for returns from active, passive (index fund) and tax loss-advantaged equity; hedge fund returns are tax-wise similar to active equity; 30% of appreciation from natural resources and private equity are realized each year as long-term gains; and, 30% of appreciation from real estate are realized each year as ordinary income. They ignore any effects of portfolio liquidation. Using Yale Endowment allocations and U.S. tax rules as of  the end of 2013, along with benchmark index covariances during December 1998 through June 2013, they find that:

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Risk parity asset strategies generally make large allocations to low-volatility assets such as bonds, which tend to fall in value when interest rates rise. Is risk parity a safe strategy when rates rise? In their June 2014 research note entitled “Risk-Parity Strategies at a Crossroads, or, Who’s Afraid of Rising Yields?”, Fabian Dori, Manuel Krieger, Urs Schubiger and Daniel Torgler examine how the rising interest rate environment of the U.S. in the 1970s affects risk parity performance. They also examine how inflation and economic growth affect risk parity performance. They use the yield on the 10-year U.S. Treasury note (T-note) as a proxy for the interest rate. Their risk parity model uses 40-day past volatility for risk weighting and allows leverage to target an annualized portfolio volatility (7.5%, per Fabian Dori). They consider two benchmark portfolios: conservative, allocating 60% to bonds, 30% to stocks and 10% to commodities; and, aggressive, allocating 40% to bonds, 40% to stocks and 20% to commodities. They rebalance all portfolios daily, including estimated transaction costs. They compare six-month returns of risk parity and benchmark portfolios across ranked fifths (quintiles) of contemporaneous six-month changes in interest rates, inflation and Gross Domestic Product (GDP) growth rate. Using daily levels of a generic 10-year T-note, the S&P 500 Index and the Goldman Sachs Commodity Index during January 1970 through June 1996 and actual daily futures prices for 2-year, 5-year and 10-year T-notes, the S&P 500 Index, the NASDAQ 100 Index and the DJ UBS Commodity Index during July 1996 through April 2014, along with contemporaneous interest rate, inflation and GDP data, they find that: Keep Reading

The “Simple Asset Class ETF Momentum Strategy” each month allocates all funds to the one of the following eight asset class exchange-traded funds (ETF), or cash, with the highest total return over the past five months:

PowerShares DB Commodity Index Tracking (DBC)
iShares MSCI Emerging Markets Index (EEM)
iShares MSCI EAFE Index (EFA)
SPDR Gold Shares (GLD)
iShares Russell 1000 Index (IWB)
iShares Russell 2000 Index (IWM)
SPDR Dow Jones REIT (RWR)
iShares Barclays 20+ Year Treasury Bond (TLT)
3-month Treasury bills (Cash)

“Simple Asset Class ETF Momentum Strategy Robustness/Sensitivity Tests” shows that, among uniform ranking intervals, five months is optimal. Citing the optimality of a three-month ranking interval in “Simple Debt Class Mutual Fund Momentum Strategy”, a subscriber inquired whether using a three-month ranking interval just for TLT might improve Simple Asset Class ETF Momentum Strategy performance. To investigate more generally, we compute net terminal values for 108 variations of the strategy by letting the ranking interval for each asset range from one to 12 months, while holding the ranking interval for all other assets at five months. In order to compare ranking intervals of different lengths, we use the average total return per month for ranking. For example, the average monthly total return for a five-month ranking interval is the five-month total return divided by five. Using monthly dividend-adjusted closes for the asset class proxies and the yield for Cash during July 2002 (or inception if not available then) through May 2014 (141 months), we find that:

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A subscriber suggested an alternative to the “Simple Asset Class ETF Momentum Strategy” that weights asset class ETFs according to five-month past return ranking (such as 35-25-20-10-4-3-2-1) rather than allocating all funds to the winner. Do the diversification benefits of this alternative outweigh the loss of momentum purity? To investigate, we return 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 1000 Index (IWB)
iShares Russell 2000 Index (IWM)
SPDR Dow Jones REIT (RWR)
iShares Barclays 20+ Year Treasury Bond (TLT)
3-month Treasury bills (Cash)

As one benchmark, we allocate all funds at the end of each month to the asset class ETF or cash with the highest total return over the past five months (5-1). As another benchmark, we maintain an equal-weighted (EW), monthly rebalanced portfolio of all nine asset classes. As alternatives, we test two momentum rank-weighted (RW), linearly-scaled combinations of all nine classes, one steep across ranks and one shallow. We also test EW combinations of the Top 5, Top 4, Top 3 and Top 2 momentum ranks. Using monthly adjusted closing prices for the asset class proxies and the yield for Cash over the period February 2006 (the earliest all ETFs are available) through May 2014 (100 months), we find that: Keep Reading

We have updated the detail at “Momentum Strategy” to incorporate the historical data changes described in “Simple Asset Class ETF Momentum Strategy Data Changes”. The principal effects are to decrease the performance of the Top 1 portfolio and increase the performance of the Top 2 portfolio.

Over the coming week, we will accordingly update much of the supporting research listed at “Momentum Strategy”.

Does the relative performance of 10-year U.S. Treasuries and 30-year U.S. Treasuries offer a useful risk-on/risk-off regime change signal? In their February 2014 paper entitled “An Intermarket Approach to Tactical Risk Rotation Using the Signaling Power of Treasuries to Generate Alpha and Enhance Asset Allocation” (the National Association of Active Investment Managers’ 2014 Wagner Award third place winner), Michael Gayed and Charles Bilello examine whether the relationship between the monthly total returns of the 10-year and 30-year Treasuries usefully indicate when to hold (or tilt toward) Treasuries versus stocks. They reason that informed investors migrate toward intermediate-term (long-term) Treasuries when they anticipate strong (weak) economic conditions. Therefore, the relative strength of 10-year and 30-year Treasuries signals when to take an aggressive or defensive investment posture. Using monthly total returns for 10-year and 30-year Treasuries and for the broad U.S. stock market during April 1977 through December 2013, they find that: Keep Reading

What factors make asset class diversification work? To investigate empirically, we consider the following mix of exchange-traded funds (ETF) as asset class proxies (the same used in “Simple Asset Class ETF Momentum Strategy”):

PowerShares DB Commodity Index Tracking (DBC)
iShares MSCI Emerging Markets Index (EEM)
iShares MSCI EAFE Index (EFA)
SPDR Gold Shares (GLD)
iShares Russell 1000 Index (IWB)
iShares Russell 2000 Index (IWM)
SPDR Dow Jones REIT (RWR)
iShares Barclays 20+ Year Treasury Bond (TLT)
3-month Treasury bills (Cash)

We calculate the monthly gross return-risk ratio (average monthly return divided by standard deviation of monthly returns) for an equally weighted, monthly rebalanced portfolio of all nine asset class proxies. We then recalculate the return-risk ratio nine times, each time excluding one of the assets, and relate the resulting return-risk ratios to three characteristics of the respectively excluded assets: (1) average monthly return; (2) standard deviation of monthly returns; and, (3) average (pairwise) cross-correlation of monthly returns with the other eight assets. The objective is to determine whether any of these three characteristics explain asset contribution to diversification benefit.  We ignore trading frictions associated with monthly rebalancing, which would be similar for all combinations. Using dividend-adjusted monthly returns for the above nine asset class proxies during September 2006 (so that monthly returns for all assets are available in equal-weight calculations) through April 2014 (92 monthly returns), we find that: Keep Reading

How well do long-short stock strategies work, after accounting for all costs? In their February 2014 paper entitled “Assessing the Cost of Accounting-Based Long-Short Trades: Should You Invest a Billion Dollars in an Academic Strategy?”, William Beaver, Maureen McNichols and Richard Price examine the net attractiveness of several long-short strategies as stand-alone investments (as for a hedge fund) and as diversifiers of the market portfolio. They also consider long-only versions of these strategies. Specifically, they consider five anomalies exposed by the extreme tenths (deciles) of stocks sorted by:

1. Book-to-Market ratio (BM) measured annually.
2. Operating Cash Flow (CF) measured annually as a percentage of average assets.
3. Accruals (AC) measured annually as earnings minus cash flow as a percentage of average assets.
4. Unexpected Earnings (UE) measured as year-over-year percentage change in quarterly earnings.
5. Change in Net Operating Assets (ΔNOA) measured annually as a percentage of average assets.

For strategies other than UE, they reform strategy portfolios (long the “good” decile and short the “bad” decile) annually at the end of April using accounting data from the prior fiscal year. For UE, they reform the portfolio at the ends of March, June, September and December using prior-quarter data. They highlight cost of capital, financing costs and rebates received on short positions, downside risk and short-side contribution to performance. They assume that the same amount of capital supports either a long-only portfolio, or a portfolio with equal long and short sides (with the long side satisfying Federal Reserve Regulation T collateral requirements for the short side). They account for shorting costs as fees for initiating short positions plus an ongoing collateral rate set at least as high as the federal funds rate, offset by a rebate of 0.25% per year interest on short sale proceeds. They estimate stock trading costs as the stock-by-stock percentage bid-ask spread. They consider two samples (including delistings): (1) all U.S. listed stocks; and, (2) the 20% of stocks with the largest market capitalizations. Using accounting data as described above for all non-ADR firms listed on NYSE, AMEX and NASDAQ for fiscal years 1992 through 2011, and associated monthly stock returns during May 1993 through April 2013, they find that: Keep Reading

Under what conditions is periodic rebalancing a successful “volatility harvesting” strategy? In his February 2014 paper entitled “Disentangling Rebalancing Return”, Winfried Hallerbach analyzes the return from periodic portfolio rebalancing by decomposing its effects into a volatility return and a dispersion discount. He defines:

• Rebalancing return as the difference in (geometric) growth rates between periodically rebalanced and buy-and-hold portfolios.
• Volatility return as the difference in growth rates between a periodically rebalanced portfolio and the equally weighted average growth rate of its component assets.
• Dispersion discount as the difference in growth rates between a buy-and-hold portfolio and the equally weighted average growth rate of portfolio assets.

Based on mathematical derivations with some approximations, he concludes that: Keep Reading

What drives the performance of risk parity asset allocation, and on what asset classes does it therefore work best? In their January 2014 paper entitled “Inter-Temporal Risk Parity: A Constant Volatility Framework for Equities and Other Asset Classes”, Romain Perchet, Raul Leote de Carvalho, Thomas Heckel and Pierre Moulin employ simulations and backtests to explore the conditions/asset classes for which a periodically rebalanced risk parity asset allocation enhances portfolio performance. Specifically, they examine contemporaneous interactions between risk parity performance and each of return-volatility relationship, return volatility clustering and fatness of return distribution tails (kurtosis). They then compare different ways of predicting volatility for risk parity implementation. Finally, they backtest volatility prediction/risk parity allocation effectiveness separately for stock, commodity, high-yield corporate bond, investment-grade corporate bond and government bond indexes (each versus the risk-free asset). They optimize volatility prediction model parameters annually based on an expanding window of historical data. They forecast volatility based on one-year rolling historical daily return data. Using daily total returns in U.S. dollars for the S&P 500 Index during 1980 through 2012 and for the Russell 1000, MSCI Emerging Market, S&P Commodities, U.S. High Yield Bond, U.S. Corporate Investment Grade Bond and U.S. 10-Year Government Bond indexes and the 3-month U.S. Dollar LIBOR rate (as the risk-free rate) during January 1988 through December 2012, they find that: Keep Reading