- Defensive Asset Allocation (DAA) builds on the framework designed for Vigilant Asset Allocation (VAA)
- For DAA the need for crash protection is quantified using a separate “canary” universe instead of the full investment universe as with VAA
- DAA leads to lower out-of-market allocations and hence improves the tracking error due to higher in-the-market-rates
In our brand new SSRN-paper “Breadth Momentum and the Canary Universe: Defensive Asset Allocation (DAA)” we improve on our Vigilant Asset Allocation (VAA, see post) by the introduction of a separate “canary” universe for signaling the need for crash protection, using the concept of breadth momentum (see VAA). This protective universe functions as an early warning system similar to the canary in the coal mine back in the day. For DAA the amount of cash is governed by the number of canary assets with negative momentum. The risky part is still based on relative momentum, just like VAA. The resulting investment strategy is called Defensive Assets Allocation (DAA). The aim of DAA is to lower the average cash (or bond) fraction while keeping nearly the same degree of crash protection as with VAA.
Using a very simple model from 1925 to 1970 with only the S&P 500 total return index as investment asset, we arrive at a two-asset canary universe (VWO and BND) combined with a protective B2 breadth momentum setting, which defines DAA’s core elements.
The DAA concept turns out to be quite effective for nearly all four universes examined in our VAA-paper from 1971 to 2018. The average cash fraction of DAA is often less than half that of VAA’s (below 30% instead of nearly 60%), while return and risk are similar and for recent years even better. Deploying a separate “canary” universe for signaling the need for crash protection also improves the tracking error with respect to the passive (buy-and-hold) benchmark due to higher in-the-market-rates than with VAA. The separate “canary” universe also limits turnover. This makes DAA less sensitive for rising cash (or bond) yields, which is key in view of recent low rates.
To crystallize the DAA concept:
- When both canary assets VWO and BND register negative 13612W momentum, invest 100% in the single best bond of the cash universe;
- When only one of the canary assets VWO or BND registers negative momentum, allocate 50% in the top half of the best risky assets, while applying equal weights, and invest the remaining 50% in the best bond of the cash universe;
- When none of canary assets VWO and BND register negative momentum, indicating the risk of a crash is deemed low, invest 100% in the full top risky assets, again applying equal weights.