Optimizing Portfolios: Simple vs. Sophisticated Allocation Strategies

Portfolio allocation is an important research area. In this issue, we explore not only asset allocation but also the allocation of strategies. Specifically, I discuss tactical asset and trend-following strategy allocation.

Tactical Asset Allocation: From Simple to Advanced Strategies

Tactical Asset Allocation (TAA) is an active investment strategy that involves adjusting the allocation of assets in a portfolio to take advantage of short- to medium-term market opportunities. Unlike strategic asset allocation, which focuses on long-term asset allocation based on a fixed mix, TAA seeks to exploit market inefficiencies by overweighting or underweighting certain asset classes depending on market conditions, economic outlooks, or valuation anomalies. This approach allows investors to be more flexible and responsive to changing market environments, potentially improving returns while managing risk.

Reference [1] examines five approaches to tactical asset allocation. They are,

  1. The SMA 200-day strategy, which uses the price of an asset relative to its 200-day moving average.
  2. The SMA Plus strategy, which builds on the SMA 200-day by adding a volatility signal to the trend signal, dynamically adjusting allocations between risky assets and cash.
  3. The Dynamic Tactical Asset Allocation (DTAA) strategy, which applies the same trend and volatility signals as SMA Plus but across the entire portfolio, rather than on individual assets.
  4. The Risk Parity method, popularized by Ray Dalio’s All Weather Portfolio, equalizes the risk contributions of different asset classes.
  5. The Maximum Diversification method, which aims to maximize the diversification ratio by balancing individual asset volatilities against overall portfolio volatility.

Findings

– The SMA strategy provides strong risk-adjusted returns by shifting to cash during downturns, though it may miss early recovery phases.

– SMA Plus builds on SMA by adding a more dynamic allocation approach, achieving higher returns but at a slightly increased risk level.

– The DTAA strategy yields the highest returns but experiences significant drawdowns due to aggressive equity exposure and limited risk management.

– Risk Parity and Maximum Diversification focus on stability, offering lower returns with minimal volatility, making them suitable for conservative investors.

In short, TAA based on a simple moving average still delivers the best risk-adjusted return.

This is an interesting and surprising result. Does this prove once again that simpler is better?

Reference

[1] Mohamed Aziz Zardi, Quantitative Methods of Dynamic Tactical Asset Allocation, HEC – Faculty of Business and Economics, University of Lausanne, 2024

Using Trends and Risk Premia in Portfolio Allocation

Trend-following strategies play a crucial role in portfolio management, but constructing an optimal portfolio based on these signals requires a solid theoretical foundation. Reference [2] builds on previous research to develop a unified framework that integrates an autocorrelation model with the covariance structure of trends and risk premia.

Findings

– The paper develops a theoretical framework to derive implementable solutions for trend-following portfolio allocation.

– The optimal portfolio is determined by the covariance matrix of returns, the covariance matrix of trends, and the risk premia.

– The study evaluates five well-established portfolio strategies: Agnostic Risk Parity (ARP), Markowitz, Equally Weighted, Risk Parity (RP), and Trend on Risk Parity (ToRP).

– Using daily futures market data from 1985 to 2020, covering 24 stock indexes, 14 bond indexes, and 9 FX pairs, the authors assess the performance of these portfolios.

– The optimal combination of the three best portfolios—ARP (19.5%), RP (51%), and ToRP (30%)—achieves a Sharpe ratio of 1.37, balancing traditional and alternative approaches.

– The RP portfolio, representing a traditional diversified approach, is a key driver of performance, aligning with recent literature.

– The combination of ARP and ToRP offers the best Sharpe ratio for trend-following strategies, as it minimizes asset correlation.

In the context of a portfolio optimization problem, the article solved the optimal allocation amongst a set of trend-following strategies. It utilized the covariance matrix of returns, trends, and risk premia in its optimization algorithm. The allocation scheme combined both traditional and alternative approaches, offering a better Sharpe ratio than each of the previous methods individually.

Reference

[2] Sébastien Valeyre, Optimal trend following portfolios, (2021), arXiv:2201.06635

Closing Thoughts

We have discussed both asset and strategy allocation, one advocating a relatively simple approach, while the other is more sophisticated. Each method has its advantages, depending on the investor’s objectives and risk tolerance. A well-balanced portfolio may benefit from integrating both approaches to achieve optimal performance and diversification.

Capturing Volatility Risk Premium Using Butterfly Option Strategies

The volatility risk premium is a well-researched topic in the literature. However, less attention has been given to specific techniques for capturing it. In this post, I’ll highlight strategies for harvesting the volatility risk premium.

Long-Term Strategies for Harvesting Volatility Risk Premium

Reference [1] discusses long-term trading strategies for harvesting the volatility risk premium in financial markets. The authors emphasize the unique characteristics of the volatility risk premium factor and propose trading strategies to exploit it, specifically for long-term investors.

Findings

– Volatility risk premium is a well-known phenomenon in financial markets.

– Strategies designed for volatility risk premium harvesting exhibit similar risk/return characteristics. They lead to a steady rise in equity but may suffer occasional significant losses. They’re not suitable for long-term investors or investment funds with less frequent trading.

– The paper examines various volatility risk premium strategies, including straddles, butterfly spreads, strangles, condors, delta-hedged calls, delta-hedged puts, and variance swaps.

– Empirical study focuses on the S&P 500 index options market. Variance strategies show substantial differences in risk and return compared to other factor strategies.

– They are positively correlated with the market and consistently earn premiums over the study period. They are vulnerable to extreme stock market crashes but have the potential for quick recovery.

– The authors conclude that volatility risk premium is distinct from other factors, making it worthwhile to implement trading strategies to harvest it.

Reference

[1] Dörries, Julian and Korn, Olaf and Power, Gabriel, How Should the Long-term Investor Harvest Variance Risk Premiums? The Journal of Portfolio Management   50 (6) 122 – 142, 2024

Trading Butterfly Option Positions: a Long/Short Approach

A butterfly option position is an option structure that requires a combination of calls and/or puts with three different strike prices of the same maturity. Reference [2] proposes a novel trading scheme based on butterflies’ premium.

Findings

– The study calculates the rolling correlation between the Cboe Volatility Index (VIX) and butterfly options prices across different strikes for each S&P 500 stock.

– The butterfly option exhibiting the strongest positive correlation with the VIX is identified as the butterfly implied return (BIR), indicating the stock’s expected return during a future market crash.

– Implementing a long-short strategy based on BIR allows for hedging against market downturns while generating an annualized alpha ranging from 3.4% to 4.7%.

-Analysis using the demand system approach shows that hedge funds favor stocks with a high BIR, while households typically take the opposite position.

-The strategy experiences negative returns at the bottom of a market crash, making it highly correlated with the pricing kernel of a representative household.

-The value-weighted average BIR across all stocks represents the butterfly implied return of the market (BIRM), which gauges the severity of a future market crash.

-BIRM has a strong impact on both the theory-based equity risk premium (negatively) and the survey-based expected return (positively).

This paper offers an interesting perspective on volatility trading. Usually, in a relative-value volatility arbitrage strategy, implied volatilities are used to assess the rich/cheapness of options positions. Here the authors utilized directly the option positions premium to evaluate their relative values.

Reference

[2] Wu, Di and Yang, Lihai, Butterfly Implied Returns, SSRN 3880815

Closing Thoughts

In summary, both papers explore strategies for capturing the volatility risk premium. The first paper highlights the distinct characteristics of the volatility risk premium and outlines trading strategies tailored for long-term investors. The second paper introduces an innovative trading scheme centered around butterfly option structures. Together, these studies contribute valuable insights into optimizing risk-adjusted returns through strategic volatility trading.

Understanding Mean Reversion to Enhance Portfolio Performance

In a previous newsletter, I discussed momentum strategies. In this edition, I’ll explore mean-reverting strategies.

Mean reversion is a natural force observed in various areas of life, including sports performance, portfolio performance, volatility, asset prices, etc. In this issue, I specifically examine the mean reversion characteristics of individual stocks and indices.

Long-Run Variances of Trending and Mean-Reverting Assets

Trading strategies are often loosely divided into two categories: trend-following and mean-reverting. They’re designed to exploit the mean-reverting or trending properties of asset prices. Reference [1] provides a different perspective and approach for studying the mean-reverting and trending properties of assets. It compares the long-run variances of mean-reverting and trending assets to that of a random-walk process.

Findings

-The paper provides an alternative perspective on studying mean-reverting and trending properties of assets.

– Long-run variances of mean-reverting and trending assets are compared to a random-walk process. The paper highlights a probabilistic model for investment styles.

– Theoretical analysis indicates the variance’s direct dependence on the probability of consecutive directional movements.

– It suggests that variance may be reduced through mean reverting strategies, capturing instances of assets moving in opposing directions.

-The model is applied to US stock data. It is found that in 97 of the largest stocks, a regime of mean-reversion is prevalent.

-The paper demonstrated that relative to a random walk, the variance of these stocks is reduced due to this behavior.

-It concluded that most large-cap US stocks exhibit mean-reverting behavior.

-Mean-reverting asset prices are deemed more predictable than a random walk.

In short, the paper concluded that most large-cap US stocks are mean-reverting, and the mean reversion resulted in a reduction of the variances of the assets. This means that mean-reverting asset prices are more predictable as compared to a random walk. The opposite is true for trending assets: larger variances and less predictability.

Reference

[1] L. Middleton, J. Dodd, S. Rijavec, Trading styles and long-run variance of asset prices, arXiv:2109.08242

Mean-Reverting Trading Strategies Across Developed Markets

Reference [2] studies the mean reversion strategy of individual stocks across developed markets. It shows that the mean-reversion strategy is not profitable in all markets. However, when we apply filters for stock characteristics, the strategy becomes profitable.

Findings

-This study examined the reversal strategy in the five largest developed markets using portfolio analysis and the Fama–Macbeth (FM) regression method.

-Portfolio analysis revealed that the unconditional reversal strategy is persistent only in Germany and Japan.

-When applied to firms with higher expected liquidity provision costs, the reversal returns became stronger across all markets.

-The FM regression method provided the strongest support for the reversal strategy while accounting for key firm-related characteristics.

-Reversal returns were significantly linked to market volatility, indicating that they are more pronounced during periods of higher market liquidity costs.

-The lack of liquidity in smaller, high book-to-market, high volatility stocks contributes to their higher reversal effect.

-Small, high book-to-market ratio and volatile stocks exhibit a prominent reversal effect based on portfolio analysis.

-Traditional asset pricing models like CAPM, FF-3, and CF-4 fail to explain the observed reversal returns.

Reference

[2] Hilal Anwar Butt and Mohsin Sadaqat, When Is Reversal Strong? Evidence From Developed Markets, The Journal of Portfolio Management, June 2024

Closing Thoughts

We have examined the mean reversion characteristics of stocks and indices in both U.S. and international markets. Gaining insights into this dynamic can lead to better risk-adjusted returns for your portfolio.