Introducing Protective Asset Allocation

Protective Asset Allocation (PAA) is a new provident long only tactical investment strategy that combines a dual momentum approach with a vigorous capital preservation routine. The key elements of PAA are:

• dual momentum based timing and selection mechanism
• innovative c(r)ash protection routine through protective momentum
• support for separate “risk-on” and “risk-off" universes

Each of these building blocks will be explained quite comprehensively followed by a detailed comparative backtest covering 45 years (Dec. 1970 – Dec. 2015). But first be ready for a truckload of conceptual particularities ;-)

In our quest for a yield neutral absolute return performance strategy Wouter Keller and I developed PAA (long only) with its innovative protective momentum approach for capital preservation in times of market turmoil. The interested reader might consider reading our PAA-paper on SSRN too.

PAA exploits the well-defined momentum phenomenon: the empirically observed tendency for asset prices to keep moving in the same direction. By applying PAA to a broad diversified global universe of sufficiently uncorrelated ETFs, PAA will auto-detect bull trends that emerge. Meanwhile protective momentum keeps guard over global market-breadth to adjust the “equity” : “cash” spread of the portfolio. And when trends shift, PAA catches the change and adapts, be it bullish or bearish. In doing so PAA is purely mechanical, so there is no need second guessing market conditions nor predicting trends. PAA is capable of delivering absolute return performance with 1-year-rolling-return win rates of more than 95% (R1yWin>0%) and 99% (R1yWin>-5%).

Equity chart of the PAA strategy demonstrating high return/risk performance

A Primer on Elastic Asset Allocation According to Keller & Butler

In a brand new 2014 paper "A Century of Generalized Momentum; From Flexible Asset Allocations (FAA) to Elastic Asset Allocation (EAA)" Wouter Keller and Adam Butler reveal a new methodology for rotational tactical asset allocation. While FAA (see paper or post) was build on the concept of generalized momentum by assigning ranks to returns, volatilities and correlations, the EAA concept adds a new level of generalization by moving from ordinal ranking to cardinal "elasticities". Admittedly the full EAA methodology can appear rather daunting, but with some simplifications the concept becomes quite accessible in the end. So hang in there, you'll soon be all right ;-)

EAA main formula

EAA controls the optimal portfolio asset allocation through an ingenious exponential scoring function of estimates for return (ri), volatility (vi) and index correlation (ci) as well as applying a portfolio concentration exponent: the non-negative elasticities wR, wV, wC respectively wS.

$\mathit{wi}\sim \mathit{zi}={\left(\frac{{\mathit{ri}}^{\mathit{wR}}\cdot {(1-\mathit{ci})}^{\mathit{wC}}}{{\mathit{vi}}^{\mathit{wV}}}\right)}^{\mathit{wS}}$ , if ri > 0 else wi = zi = 0, for i = 1 ... N

where for each asset i in an N-sized portfolio:
- wi is the normalized proportional optimal portfolio weight, where the summation of weights is equal to 100%
- zi is the generalized momentum score
- ri is the average return (total or excess*) calculated over the last 1, 3, 6 and 12 months
- vi is the volatility of total return measured over the last 12 months
- ci is the correlation of total returns with the equal weighted universe index measured over the last 12 months.

The four geometrical weights wR, wV, wC and wS are called "elasticities" due to their relative impact on the three terms (ri, vi, ci) of the EAA scoring function. Remember from math class:
- $x^{0.5}=\sqrt{x}$  and
- ${(x^{0.5}\cdot y)}^2=x^{(0.5\cdot 2)}\cdot y^2=x\cdot y^2$.
So when applying exponential values ranging between 1 to 0 the scoring effect is mitigated, while values ranging from 1 to 2 amplify the effect of the said term on the score. Note that with wS = 0 the EAA function will return zi = 1 for each and every asset, independent of ri, vi or ci (provided ri > 0). Put differently, with wS = 0 the asset allocation is equal weighted (apart from the safety net offered by a cash proxy fund, see below).

Different from FAA the proportionality with zi allows the weights wi to be not equal. Next to its exponential scoring function, EAA utilizes an optimal top quantile (TopN) of the portfolio size (N) and a C(r)ash Protection routine (CP) by allocating a proportional fraction of portfolio capital to a cash proxy fund (CPF) for every asset with non-positive return. In accordance with the concept of tactical asset allocation the portfolio is rebalanced at the end of each month.

During a stock market crash, like in 2008, the C(r)ash Protection kicks in. Note the unequal weights too (last column).

    

Flexibile Asset Allocation With C(r)ash Protection

The "Conceptual sketch" posting presented a survey for designing a portfolio that generates stable profits during every type of economic environment the investor is faced with. Stimulating as well as  challenging comments were made providing food for thought on the building blocks for such a model. During our research we came across a paper published in late 2012 by Keller and Van Putten: "Generalized Momentum and Flexible Asset Allocation (FAA), An Heuristic Approach". The interested reader is encouraged to get acquainted with the elements of FAA.

Common asset allocation strategies (like the TAA strategy) are based on the so-called "momentum anomaly", which is known for centuries. The gist of the momentum anomaly is that assets often continue their price momentum, defined as the change in price over a given lookback period. Therefore one should buy assets with the highest momentum and sell assets with the lowest momentum.

FAA incorporates new momentum factors into risk regime determination. Next to the traditional momentum factor (R) based on the Relative returns among assets, Keller and Van Putten introduced Generalized Momentum by adding these new factors: Absolute momentum (A), Volatility momentum (V) and Correlation momentum (C). In their paper Keller and Van Putten demonstrated that by expanding the traditional momentum approach, portfolio performance increases compared to the buy and hold benchmark, both in terms of return as well as risk.

Summarizing FAA, Keller and Van Putten present their strategy with an example universe of 7 index funds. Applying a 4 month lookback, from this universe at the end of each month the top 3 assets are selected through a nested ranking process of these 7 assets based on relative momentum (higher is better), volatility (lower is better) and correlations (lower is better). Last, each of the top 3 assets chosen, has to pass the absolute momentum test: if their absolute momentum is negative, just go into cash. Capital is equally allocated over the top 3 assets or if applicable into cash.

FAA was scrutinized by Empiritrage. In their full report following findings are reached:
FAA has significantly higher risk-adjusted return than an equal weight portfolio. FAA decreases maximum drawdown dramatically. FAA is robust when adjusting look-back periods. Absolute momentum can directly add value on identifying down side risk regimes and decrease maximum drawdown.

Source: Empiritrage