Research Review | 4.17.2012 | Asset Allocation

Tactical Asset Allocation Using Relative Strength
John Lewis (Dorsey Wright Money Management) | March 2012
Relative strength strategies have a long history of delivering market-beating returns. A great deal of research in this area has been devoted to models using common stocks. While some studies show that RS works well using asset class data, the body of research is not as large. Our research shows that relative strength is a very valuable factor for selecting asset classes. When looking at the relative performance of various asset classes over an intermediate-term time horizon it is certainly possible to achieve returns better than standard, broad-based benchmarks. Achieving these returns often requires patience because relative strength strategies can get out of synch with the market. However, the adaptive nature of relative strength allows the process to adapt to the changing leadership over time.


Value and Momentum Tactical Asset Allocation
Wesley R. Gray (Empiritrage, LLC), et al. | March 2012
We present a concise quantitative method for combining value and momentum strategies in a tactical asset allocation framework by directly comparing the attractiveness of valuations across a broad range of asset classes. Our broad and diverse publicly traded asset classes include public equity, investment grade and high yield bonds, cash, Treasury Inflation Protected Securities (TIPS), commodity and real estate. We refine the basic yield approach to valuation by standardizing the value signal using the Z-score. By tactically adjusting the weight of each asset class based on its perceived value and momentum signals, our model shows significant improvement in overall portfolio performance.
Diversification of Equity with VIX Futures: Personal Views and Skewness Preference
Carol Alexander and Dimitris Korovilas (University of Reading) | March 2012
A comprehensive description of the trading and statistical characteristics of VIX futures and their exchange-traded notes motivates our study of their benefits to equity investors seeking to diversify their exposure. We analyze when diversification into VIX futures is ex-ante optimal for standard mean-variance investors, then extend this to include (a) skewness preference, and (b) a moderation of personal forecasts by equilibrium returns, as in the Black-Litterman framework. An empirical study shows that skewness preference increases the frequency of diversification, but out-of-sample the optimally-diversified portfolios rarely out-perform equity alone, even according to a generalized Sharpe ratio that incorporates skewness preference, except during an extreme crisis period or when the investor has personal access to accurate forecasts of VIX futures returns.
Strategic Performance Allocation in Institutional Asset Management Firms: Behold the Power of Stars and Dominant Clients
Ranadeb Chaudhuri (Oakland University), et al. | March 2012
We identify strong and robust evidence of strategic performance allocation in the institutional money management industry, directed toward strong recent performers, the money management firms’ high-value products. The extent of strategic performance allocation varies with the product’s client power. We identify the channel through which strategic performance allocation takes place by studying four sources of variation of its extent under the cross-subsidization hypothesis (whereas such variation is not predicted by managerial talent allocation hypothesis) and find that its extent is related strongly to all four: availability of IPO opportunities, illiquidity of the products’ investment styles, cross-trading status of the firm, and custodian status of the firm. We also assess the implications of strategic performance transfer away from the products that cross-subsidize this performance.
Heuristic Portfolio Trading Rules with Capital Gain Taxes
Michael Gallmeyer (University of Virginia) and Marcel Marekwicaz (Copenhagen Business School) | February 2012
This paper studies the out-of-sample performance of portfolio trading strategies when an investor faces capital gain taxation and proportional transaction costs. Under no capital gain taxation and no transaction costs, we show that, consistent with past literature such as DeMiguel, Garlappi, and Uppal (2009b), a simple 1/N [equal weight] trading strategy is not dominated out-of-sample by a variety of optimizing trading strategies. A notable exception of a strategy that does outperform 1/N in our analysis is the parametric portfolios of Brandt, Santa-Clara, and Valkanov (2009). With dividend and realization-based capital gain taxes, the welfare costs of the taxes are large with the cost being as large as 30% of wealth in some cases. Overlaying simple tax trading heuristics on these trading strategies improves out-of-sample performance. In particular, the 1/N trading strategy’s welfare gains improve when a variety of tax trading heuristics are also imposed. For medium to large transaction costs, no trading strategy can outperform a 1/N trading strategy augmented with a tax heuristic, not even the most tax- and transaction cost ecient buy-and-hold strategy. Our results thus show that optimal trading strategies trade risk and return considerations off against tax considerations and neither solely focus on any of the two.
Implementing Black-Litterman Using an Equivalent Formula and Equity Analyst Target Prices
Zhi Da (University of Notre Dame), et al. | December 2011
In a seminal paper, Black and Litterman (1992, BL hereafter), propose a novel way to incorporate investors’ views into asset allocation decisions within the standard mean-variance optimization framework of Markowitz (1952). In this paper, we derive a simpler formulation of the BL Model that is easier to interpret and allows for correlation between the uncertainty about the investor’s views and the asset returns…. We show that the optimal portfolio outperforms the market and this result is robust across di erent time periods and parameter choices.

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