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Summary Diversification is an effective risk-management tool, but it does not do enough for the investor that is intensely afraid of large drawdowns. We propose volatility-based allocation as an additional tool. Volatility-Based Allocation (VBA) is a two-signal model that is simple-to-implement, robust, and historically generates a favorable risk/reward return profile. 1. The first indicator in VBA is the volatility regime signal, which simply identifies Risk-On and Risk-Off market regimes. 2. The second indicator in VBA is the long-term moving average signal, which invests when the current price is above the 12-month MA, and invests in the risk-free rate otherwise. Over the March 1, 1986 to August 31, 2012 period, VBA generates a CAGR of 9.76% and a maximum drawdown of 9.64% when applied to our 5 core assets classes: domestic equity, developed equity, emerging equity, real estate, and long-term government bonds. Our volatility regime indicator outperforms the long-term moving average rule as a stand-alone risk management tool. VBA (which combines the volatility regime indicator and the long-term moving average rule) dominates the stand-alone long-term moving average.
PLEASE SEE THE DISLAIMER AND DISCLOSURES AT THE END OF THIS REPORT. The information set forth herein has been obtained or derived from sources believed by Empiritrage, LLC (Empiritrage) to be reliable. Empiritrage does not make any representation or warranty, express or implied, as to the informations accuracy or completeness, nor does Empiritrage recommend that the attached information serve as the basis of any investment decision. This document has been provided to you solely for information purposes and does not constitute an offer or solicitation of an offer, or any advice or recommendation, to purchase any securities or other financial instruments, and may not be construed as such. This document is subject to further review and revision.
1 December 2012
VBA System
VBA (Volatility-Based Allocation) Step1: Volatility Regime Step2: MA Rule
VBA Details
Step1: Volatility Regime 10-Day VIX MA > 30-Day VIX MA
No Yes
Risk-Off
S&P 500
3 1 December 2012
Risk-Free
Source: Empiritrage, LLC Research
1 December 2012
Simulation Details
1. The VIX series is spliced with OEX data. We use VIX Index from January 1, 1990 through August 31, 2012. For the period from January 1, 1986 to December 31, 1989 we use the VXO Index. 2. The following 5 asset classes are used in the back-test (referred to as the Core 5): a. FTSE NAREIT All Equity REITS Total Return Indexbenchmark for REITsFNERTR INDEX b. MSCI EAFE Indexbenchmark for investment in equity markets outside of U.S. and Canada NDDUEAFE INDEX c. MSCI EEM Indexbenchmark for investment in emerging marketsNDUEEGF INDEX d. Merrill Lynch 7-10 year government bond indexML1US10 INDEX e. SP500 IndexSPXT INDEX 3. Simulation results are from March 1, 1986 through August 31, 2012. 4. Portfolios are rebalanced monthly. 5. We utilized long-term simple moving average rules as a risk-management technique. The benefits of longterm MA rules as an effective risk-management tool was brought to the mainstream by Mebane Faber. We analyze a 12-month moving average rule (MA (2,12)) that compares the 2 month simply moving average (~40 days) and the 12 month simple moving averages (~250 days). The MA(2,12) rule is triggered if the 2 month MA goes below the 12 month MA. All MA rules are calculated off each asset class. When an MA rule is triggered, proceeds earn risk-free rate of return (measured by US T-bill). 6. No transaction costs are included in any of our analysis. All results are gross of any transaction fees, management fees, or any other fees that might be associated with executing the models in real-time.
1 December 2012
1 December 2012
Outline
1. Benchmark Performance 2. VBA & Index Performance a) SP500 b)EAFE c) EEM d)REIT e) LTR 3. VBA & Core 5 Performance
1 December 2012
SP500 9.79% 15.73% 12.07% 0.39 0.47 -50.21% -21.58% 13.52% 63.21%
LTR 8.63% 6.52% 3.81% 0.61 0.92 -9.27% -5.71% 8.73% 67.61%
KEY: SP500=S&P 500 Total Return LTR = Merril Lynch 10-year U.S. Treasury Total Return EAFE = EAFE Total Return REIT = All Equity REITS Total Return Index EEM = MSCI Emerging Markets Index Core5_EW=Core5 equal-weight returns
Summary Statistics*
CAGR Standard Deviation Downside Deviation (MAR=5%) Sharpe Ratio Sortino Ratio (MAR=5%) Worst Drawdown Worst Month Return Best Month Return Profitable Months
EAFE 6.92% 18.24% 12.66% 0.25 0.27 -56.68% -20.18% 15.58% 58.81%
REIT 10.55% 18.52% 15.81% 0.43 0.43 -68.30% -31.67% 31.02% 59.75%
EEM 12.40% 24.61% 18.82% 0.45 0.52 -61.44% -28.91% 18.98% 61.64%
Core 5 EW 10.51% 12.68% 10.67% 0.55 0.55 -47.21% -19.43% 13.48% 67.30%
VBA_SP500 9.91% 7.53% 4.75% 0.79 1.00 -8.32% -8.32% 13.52% 86.79% ---1418.27% --
Vol Regime_VIX(10,30)_SP500 10.60% 10.20% 7.81% 0.66 0.72 -26.21% -10.90% 13.52% 80.82% 44.02% 65.83% -3671.68% 0.732
MA(2,12)_SP500 10.01% 12.39% 9.97% 0.54 0.56 -29.58% -21.58% 13.52% 73.27% 30.89% 17.59% -3382.63% 0.602
SP500 9.79% 15.73% 12.16% 0.45 0.48 -50.21% -21.58% 13.52% 63.21% 48.65% 42.71% -7131.59% 0.474
Asset Pricing Model Alpha (annual) CAPM 0.05 p-value*** 0.0005 3 Factor (FF) 0.05 p-value*** 0.0002 4 Factor 0.04 p-value*** 0.0022 5 Factor 0.04 p-value*** 0.0008 ***Italics denotes p-values significant at the 5% level; robust p-values
SMB
HML
MOM
LQD
-0.07 0.0525
KEY: MA(2,12)_SP500 = Index with MA trading rule (2m vs. 12m) VBA_SP500 = Volatility regime indicator, then MA trading rule Vol Regime_VIX (10,30)_SP500 = Volatility regime indicator, only
The volatility regime indicator works; VBAvolatility regime & MA signalwork better.
1 December 2012
VBA_EAFE 8.12% 8.99% 6.92% 0.49 0.47 -21.12% -10.42% 10.62% 88.36% ---2600.71% --
Vol Regime_VIX(10,30)_EAFE 9.86% 12.94% 9.79% 0.50 0.54 -38.04% -14.46% 15.58% 79.87% 40.15% 30.15% -5610.14% 0.689
MA(2,12)_EAFE 6.87% 13.19% 10.28% 0.31 0.29 -26.43% -14.01% 14.06% 73.90% 57.53% 90.95% -4273.89% 0.684
EAFE 6.92% 18.24% 12.66% 0.27 0.30 -56.68% -20.18% 15.58% 58.81% 50.97% 69.85% -8351.48% 0.493
Asset Pricing Model Alpha (annual) CAPM 0.04 p-value*** 0.0372 3 Factor (FF) 0.04 p-value*** 0.0360 4 Factor 0.03 p-value*** 0.0992 5 Factor 0.03 p-value*** 0.0724 ***Italics denotes p-values significant at the 5% level; robust p-values
SMB
HML
MOM
LQD
-0.05 0.1798
KEY: MA(2,12)_EAFE = Index with MA trading rule (2m vs. 12m) VBA_EAFE = Volatility regime indicator, then MA indicator Vol Regime_VIX (10,30)_EAFE = Volatility regime indicator, only
The volatility regime indicator works; VBAvolatility regime & MA signalwork better.
10
1 December 2012
VBA_EEM 13.49% 12.26% 7.89% 0.78 1.07 -24.31% -13.53% 15.59% 88.36% ---3336.07% --
Vol Regime_VIX(10,30)_EEM 15.18% 16.97% 12.53% 0.69 0.85 -45.64% -17.49% 17.15% 80.50% 49.03% 62.81% -6077.38% 0.712
MA(2,12)_EEM 13.54% 18.19% 14.10% 0.60 0.69 -35.41% -25.06% 18.98% 75.79% 39.00% 32.66% -4725.16% 0.668
EEM 12.40% 24.61% 18.80% 0.46 0.54 -61.44% -28.91% 18.98% 61.64% 47.88% 71.36% -10809.94% 0.491
Asset Pricing Model Alpha (annual) CAPM 0.08 p-value*** 0.0003 3 Factor (FF) 0.08 p-value*** 0.0004 4 Factor 0.08 p-value*** 0.0010 5 Factor 0.07 p-value*** 0.0020 ***Italics denotes p-values significant at the 5% level; robust p-values
SMB
HML
MOM
LQD
0.04 0.3939
KEY: MA(2,12)_EEM = Index with MA trading rule (2m vs. 12m) VBA_EEM = Volatility regime indicator, then MA indicator Vol Regime_VIX (10,30)_EEM = Volatility regime indicator, only
The volatility regime indicator works; VBAvolatility regime & MA signalwork better.
11
1 December 2012
VBA_REIT 10.40% 8.63% 5.41% 0.75 0.98 -14.39% -10.88% 10.39% 84.59% ---1807.35% --
Vol Regime_VIX(10,30)_REIT 12.64% 12.15% 7.49% 0.73 1.02 -24.63% -17.31% 31.02% 78.62% 37.07% 42.21% -2789.50% 0.693
MA(2,12)_REIT 11.01% 12.07% 9.35% 0.63 0.68 -27.04% -15.24% 10.39% 70.75% 33.98% 24.62% -3585.71% 0.710
REIT 10.55% 18.52% 15.81% 0.44 0.44 -68.30% -31.67% 31.02% 59.75% 42.47% 31.66% -7157.83% 0.459
Asset Pricing Model Alpha (annual) CAPM 0.06 p-value*** 0.0007 3 Factor (FF) 0.05 p-value*** 0.0014 4 Factor 0.05 p-value*** 0.0017 5 Factor 0.05 p-value*** 0.0022 ***Italics denotes p-values significant at the 5% level; robust p-values
SMB
HML
MOM
LQD
0.02 0.5620
KEY: MA(2,12)_REIT = Index with MA trading rule (2m vs. 12m) VBA_REIT = Volatility regime indicator, then MA indicator Vol Regime_VIX (10,30)_REIT = Volatility regime indicator, only
The volatility regime indicator works; VBAvolatility regime & MA signalwork better.
12
1 December 2012
VBA_LTR 5.73% 4.30% 3.36% 0.43 0.20 -7.74% -5.71% 5.22% 84.59% ---1185.14% --
Vol Regime_VIX(10,30)_LTR 6.13% 4.48% 3.38% 0.50 0.32 -7.74% -5.71% 5.22% 82.08% 20.85% 2.01% -1185.14% 0.951
MA(2,12)_LTR 8.05% 6.20% 4.20% 0.67 0.71 -7.30% -5.71% 8.73% 72.33% 8.11% 2.01% -1458.99% 0.670
LTR 8.63% 6.52% 4.08% 0.72 0.86 -9.27% -5.71% 8.73% 67.61% 5.79% 0.00% -1546.69% 0.633
SMB
HML
MOM
LQD
0.00 0.8280
KEY: MA(2,12)_LTR = Index with MA trading rule (2m vs. 12m) VBA_LTR = Volatility regime indicator, then MA Vol Regime_VIX (10,30)_LTR = Volatility regime indicator, only
VBA, the volatility regime only, and MA rules dont work in the context of long-bonds.
13
1 December 2012
VBA_Core 5 EW 9.76% 5.28% 3.57% 1.07 1.26 -9.64% -4.86% 6.32% 87.42% ---1166.77% --
Vol Regime Only_Core 5 EW 11.26% 8.24% 6.01% 0.88 1.01 -26.22% -8.85% 13.48% 84.59% 30.50% 44.22% -2487.00% 0.720
Core 5 EW_MA 10.37% 8.30% 6.72% 0.77 0.78 -18.96% -11.90% 7.96% 71.38% 27.80% 15.58% -1967.53% 0.622
Core 5 EW 10.51% 12.68% 10.67% 0.55 0.55 -47.21% -19.43% 13.48% 67.30% 47.49% 49.75% -5204.84% 0.467
Asset Pricing Model Alpha (annual) CAPM 0.05 p-value*** 0.0000 3 Factor (FF) 0.05 p-value*** 0.0000 4 Factor 0.04 p-value*** 0.0000 5 Factor 0.04 p-value*** 0.0000 ***Italics denotes p-values significant at the 5% level; robust p-values
SMB
HML
MOM
LQD
-0.01 0.5697
KEY: Core5_EW=Core5 equal-weight returns Core5 EW_MA = MA indicator applied on individual assets, then equal-weighted returns Vol Regime_Only_Core5 EW = Volatility regime indicator applied to Core 5 VBA_Core5 EW = Volatility regime indicator, then MA indicator, applied to the Core 5
The volatility regime indicator works; VBAvolatility regime & MA signalwork better.
14
1 December 2012
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1 December 2012
VBA controls risk during bear markets and participates in bull markets.
17 1 December 2012
Source: Empiritrage, LLC Research
VBA consistently controls risk; Core5 EW strains during the 2008 Financial Crisis as correlations go to 1.
21 1 December 2012
Source: Empiritrage, LLC Research
DISCLAIMER
The views expressed are the views of the authors and are subject to change at any time based on market and other conditions. This document shall not constitute an offer to sell or the solicitation of any offer to buy any security and should not be construed as such. References to specific securities and issuers are for illustrative purposes only and not intended to be, and should not be interpreted as, recommendations to purchase or sell such securities. While all the information prepared for this document is believed to be accurate, Empiritrage, LLC makes no express warranty as to the completeness or accuracy, nor can it accept responsibility for errors appearing in the document. Performance figures contained herein are unaudited and prepared by Empiritrage, LLC. They are intended for illustrative purposes only. Past performance is not indicative of future results, which may vary. There is a risk of substantial loss associated with trading commodities, futures, options and other financial instruments. Before trading, investors should carefully consider their financial position and risk tolerance to determine if the proposed trading style is appropriate. Investors should realize that when trading futures, commodities and/or granting/writing options one could lose the full balance of their account. It is also possible to lose more than the initial deposit when trading futures and/or granting/writing options. All funds committed to such a trading strategy should be purely risk capital. Hypothetical performance results (e.g., quantitative backtests) have many inherent limitations, some of which, but not all, are described herein. No representation is being made that any fund or account will or is likely to achieve profits or losses similar to those shown herein. In fact, there are frequently sharp differences between hypothetical performance results and the actual results subsequently realized by any particular trading program. One of the limitations of hypothetical performance results is that they are generally prepared with the benefit of hindsight. In addition, hypothetical trading does not involve financial risk, and no hypothetical trading record can completely account for the impact of financial risk in actual trading. For example, the ability to withstand losses or adhere to a particular trading program in spite of trading losses are material points which can adversely affect actual trading results. The hypothetical performance results contained herein represent the application of the quantitative models as currently in effect on the date first written above and there can be no assurance that the models will remain the same in the future or that an application of the current models in the future will produce similar results because the relevant market and economic conditions that prevailed during the hypothetical performance period will not necessarily recur. There are numerous other factors related to the markets in general or to the implementation of any specific trading program which cannot be fully accounted for in the preparation of hypothetical performance results, all of which can adversely affect actual trading results. Hypothetical performance results are presented for illustrative purposes only. There is no guarantee, express or implied, that long-term return and/or volatility targets will be achieved. Realized returns and/or volatility may come in higher or lower than expected.
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1 December 2012