Systematic Methods for Asset Allocation

Eugene A DurenardEric S Hirschberg

Jul-08

Introduction

We present an example of the application of systematic trend-following models to create along only asset allocation strategy that outperforms the static mean-variance optimalallocation.Our goal is to illustrate the applicability of systematic strategies to asset-liability managementproblems, an area where such techniques have not been widely introduced up to now. It isour view that such an approach presents a clear business advantage by transferring someknow-how and experience from the proprietary trading business to the institutionalallocation side of the business thereby enhancing overall returns for the allocator.

Static Analysis

In the following example we take 4 asset classes, represented by SPX, the 10Y US Yieldbenchmark, the CRB Index and the Overnight Repo rate, from 1980 to 2008. We createdaily return series from those.By the classic mean-variance analysis we come up with a deliberately over-fit optimalportfolio on SPX, 10Y and CRB for the whole period 1980-2008. This portfolio has noallocation to cash (Repo) – it is long only and fully invested into the 3 assets.

SPXUS10YRCRBON RepoMV_Portfolio

Annual Return 9.56% 9.22% 1.94% 6.00% 8.79%Annual Vol 16.08% 12.77% 10.36% 0.33% 9.98%Absolute Sharpe

0.590.720.1918.130.88Optimal Weights0.470.450.0801

The above optimal portfolio is based on long-term covariances and mean returns. To a largeextent that choice is most of the time sub-optimal as expected returns are proxied on long-term average returns and subsequent the realised returns tend to have large deviations fromsuch means. Also the holding time of such a portfolio is usually shorter than the time neededfor realised returns to be “averaged-out” to their long-term means which requires more thanone business cycle.

Dynamic Approach

To address the shortfalls of the optimal MV allocation process, we take the following approach. We observe that all the assets concerned exhibit sustained multi-week trends. Thisis not an observation based on the 1980-2008 sample but on substantially longer timeperiod* . We will therefore accept that behaviour as a valid component of the return processand try to exploit it systematically to vary portfolio weights according to a measure of momentum. The basic idea coming from any trader’s thinking is: “Don’t Fight the Trend!”.

We will therefore underweight assets that have negative momentum, overweight ones withpositive momentum and put the balance into cash (Repo) so as to always maintain a long-only non leveraged portfolio. We first construct 3 Trend Indicators TRD_SPX , TRD_10Y and TRD_CRB by taking same exponential moving averages of prices and yields: TRD_A = EMA(A, 0.01) for eachasset A. (It makes sense to use yields for Fixed Income and not prices as this is how themarket thinks about bond investing).For each asset A we then build a discrete momentum indicator MOM_A valued at{NEGATIVE, NEUTRAL, POSITIVE} in the following manner, with neutrality thresholdX = 1.5%:For Prices:If A > TRD_A*(1 + X) then MOM_A = POSITIVEIf A < TRD_A/(1 + X) then MOM_A = NEGATIVEElse MOM_A = NEUTRALFor Yields:If A > TRD_A*(1 + X) then MOM_A = NEGATIVEIf A < TRD_A/(1 + X) then MOM_A = POSITIVEElse MOM_A = NEUTRAL We then choose the allocations to our Dynamic Portfolio according to the following matrix,and where rebalancing is done on the close:

SPXUS10YRCRBPOSITIVE

0.3 0.5 0.2

NEUTRAL

0.15 0.25 0.1

NEGATIVE

0 0 0

Any excess is invested into the Overnight Repo. So for example if we have a positivemomentum on SPX but negative on bonds and neutral on CRB then our allocation will be30% to stocks, 10% to CRB and 60% to overnight, with no allocation to 10Y bonds.Each day we calculate the proportion of the portfolio thus turned over. We attach atransaction cost of 15bp of nominal value to each trade. It comes out that the averageturnover per trading day is 3% of the portfolio which corresponds to a drag of about 1.2%per year. Accounting for those transaction costs we get the following results:

Average Annual Return 7.61% Average Annual Volatility 5.91% Absolute Sharpe 1.29