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There is something very attractive about vintage items that just wont die.
They just keep coming back. Same philosophy but better up-to-date
technology.
Its not just cars. Its investment strategies, too.
Vintage strategies are often simple, easy to execute and provide amble 'out-ofsample' data. In other words one can see how they performed in real life years
after they have been proposed. And like the VW bug, they are "safe" choices.
Tried and true.
Can you imagine a 1965 VW running in the Autobahn?
Although the essence counts for a lot, for the car to survive at today's highway
speeds the tech needs to be up to date.
So lets take my favourite oldie and bring it up to speed: Harry Brownes
Permanent Portfolio.
From Investopedia:
Browne believed that each of the aforementioned four asset classes would thrive in
one of the four possible macroeconomic scenarios that exist.
Not bad. Annual return is 7.1% and maximum draw-down comes in at 17.84%
since 1992.
For a far more detailed analysis of the so called "PP" you can see Gestaltu's
excellent "PP Shakedown" series as well as Scott's Investments analysis. There
are many other articles and analysis that serve as inspiration to this article.
This decreases annual returns but also limits drawdown to under 9%. Overall,
risk adjusted returns benefit. CarMDD is at 0.8.
2. Momentum
There's been a fair amount of talk about momentum. Let's try it. We will not
limit our assets to just the few best. We are only trading four assets. Instead we
will identify the worst performer. We will decrease funds invested in that asset
and distribute those funds to the rest. So if gold underperforms all other assets,
we will sell some gold, divide the proceeds in three and buy equal amounts of
the SP550 index, Treasuries and Cash.
Let's try by pulling 15% of equity from the worst asset.
3. Mean Reversion
What about mean reversion. Can we maybe try to sell shares of the best shortterm performer and distribute the money to the others?
4. Timing
Let's use the good old simple average rule. If an asset's price is below its own
200-day simple moving average then we sell it. If it crosses up then we buy it.
Trade only on the beginning of the month.
And to get things more interesting, lets use leverage up to 2x. That the
portfolio can be invested from 0% all the way to 200%.
So now we are up to almost 12% annual returns with a drawdown of less than
13%.
What about over-fitting parameters. Lets run a permutation of all parameters
(10,401). We will assume no leverage (1x).
So lets go ahead and backtest using these 7 ETFs. We will use all layers
mentioned before, as well as 2x leverage.
One more graph: Sortino Ratio and correlation to the S&P 500 index. Again we
are looking for ballpark ranges.
Let me remind the reader that the Sortino Ratio is a risk adjusted metric similar
to the sharpe ratio but only takes into account downside volatility. The
correlation to the S&P 500 is important to many investors that already have
active investments in equity. If the strategy is too correlated to the S&P 500
then it often does not fit into larger portfolios and could be replaced by the
index.
The Sortino ration comes in above 1 while correlation to the S&P 500 index
comes in between 0.005 and 0.25.
Trading
This strategy trades monthly. For the backtests the assumption is that one buys
at the opening price of the second day of the month.
Therea plenty of ETFs to choose from. As a stock index proxy one can choose
from a wide selection that includes SPY, IVV, VOO as well as VTI, SCHB.
For treasuries one can use TLT. Gold can be traded through GLD or IAU. And
one of many options for cash is using SHY.
Conclusion:
Its always interesting to look to the past for ideas on strategy development. In
building a core, capital preservation strategy one can go back to such strategies
as Harry Brownes Permanent and Bridgwaters All-Weather Portfolio. The
main feature of these portfolios is a price-agnostic view of the markets and
basic protection by using simple asset and weight selection.
In addition, in their most basic form, they have proven themselves in true,
decade long, out-of-sample testing.
So once the essence of the strategies are incorporated, there is no reason not to
include more recent rebalancing practices that have been introduced by
academia as well as quant research: Momentum, mean reversion, volatility
targeting and the more controversial timing rules.
Robustness
But is there a bias in the look-back of the Timing rule? Is the 200-day simple
moving average chosen after-the-fact?
Well, because of the multiple layering, results seem robust in terms of picking
look-back period. In other words, momentum and timing are, in some ways,
similar in their effect. If an asset underperforms, it will go underweight using
the momentum rule until it crosses its own average and then will be sold. So
shifting through parameters in timing or momentum will have less effect than if
they stood as single rules.
As for selection bias, keep in mind that the main 4 assets have been tested outof-sample for some 20 years. The additional three assets, TIPS, Convertible
Bonds and Foreign bonds are lower volatility assets that could provide an
additional edge in the current environment and should not add excessive risk to
the strategy.
Backtesting Bias
Backtesting a strategy does not mean that backtested returns guarantee future
returns.
It does mean that one has thought about the strategy and detailed it enough as
to create rules that keep an investor disciplined and protect him from his own
emotions and the daily market noise.
Strategy
PP B&H
Bug 4
Bug 7
CAGR
7%
12%
12%
MAXDD
18%
13%
6.7%
Sharpe
0.58
0.71
1.41
Since
1992
1992
2007