Volatility Asset Management

7/29/2019 Volatility Asset Management

1/22

PLEASE SEE THE DISLAI MER 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 theattached 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 anyadvice 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.

Turning academic insight into investment performance

Applied Quantitative Strategy www.empiritrage.com

Volatility-Based Allocation (VBA)

Summary

Diversification is an effective risk-management tool, but it does not do enough for the investor that isintensely 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, andhistorically generates a favorable risk/reward return profile.

1. The first indicator in VBA is the volatility regime signal, which simply identifies Risk-On andRisk-Off market regimes.

2. The second indicator in VBA is the long-term moving average signal, which invests when thecurrent 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 maximumdrawdown 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 riskmanagement tool.

VBA (which combines the volatility regime indicator and the long-term moving average rule) dominatesthe stand-alone long-term moving average.

T: +1.773.230.4727 | F: +1.888.517.5529 | 3830 Kelley Ave. Cleveland, OH 44114 | [email protected]

Quantitative Research Team:

Wesley R. Gray, [email protected]

Tao [email protected]

Shenglan Zhang

[email protected]

Carl [email protected]
http://www.empiritrage.com/mailto:[email protected]:[email protected]:[email protected]:[email protected]:[email protected]:[email protected]:[email protected]:[email protected]:[email protected]:[email protected]:[email protected]://www.empiritrage.com/


2/22

1 December 2012 2011 Empiritrage, LLC. All Rights Reserved.2

Volatility Regime: Why does it matter?

As overall market volatility increases, risky assets tend to move in the same direction (correlations increase).

During Risk Off periods, volatility increases, equities market tend to fall, while safe assets increase in

value. Increased correlations between risky assets keep diversification benefits to a minimum.

During Risk On periods, volatility decays, equity markets rise, and safe assets decrease in value.Correlations between risky assets decrease, which keep diversification benefits at a maximum.

Diversification benefits are lower when correlations are high Diversification provides limited risk management because risky asset correlations have increased over

time.

A good risk management system needs to predict risk on and risk off regimesnavediversification does not work!

Constructing the Volatility Regime Indicator:

1. Short term MA of VIX > Long term MA of VIX ----------------------->Risk off

2. Short term MA of VIX < Long term MA of VIX ----------------------->Risk on

Underlying Alpha Driver: Risk asset markets react to spikes in VIX, but not enough conservative bias http://en.wikipedia.org/wiki/Conservatism_(belief_revision)
http://en.wikipedia.org/wiki/Conservatism_(belief_revision)http://en.wikipedia.org/wiki/Conservatism_(belief_revision)http://en.wikipedia.org/wiki/Conservatism_(belief_revision)http://en.wikipedia.org/wiki/Conservatism_(belief_revision)http://en.wikipedia.org/wiki/Conservatism_(belief_revision)http://en.wikipedia.org/wiki/Conservatism_(belief_revision)http://en.wikipedia.org/wiki/Conservatism_(belief_revision)http://en.wikipedia.org/wiki/Conservatism_(belief_revision)


3/22


VBA System

Source: Empiritrage, LLC Research

Step1: Volatility Regime

S&P 500 Price >12m MA

Risk-Free

10-Day VIX MA >30-Day VIX MA

Risk-On

No

Risk-Off

Yes

S&P 500

Yes No

Step 2: MA Rule

VBA (Volatility-Based Allocation)

Step1: Volatility Regime

Step2: MA Rule

VBA Details


4/22


Volatility Regime Signal Over Time

Volatility Regime signal is dynamic from 01/1986 through 10/2012.

Source: Empiritrage, LLC Research, Bloomberg


5/22


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 INDEXb. MSCI EAFE Indexbenchmark for investment in equity markets outside of U.S. and Canada

NDDUEAFE INDEXc. MSCI EEM Indexbenchmark for investment in emerging marketsNDUEEGF INDEXd. Merrill Lynch 7-10 year government bond indexML1US10 INDEXe. 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 long-

term MA rules as an effective risk-management tool was brought to the mainstream by Mebane Faber. Weanalyze 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 2month MA goes below the 12 month MA. All MA rules are calculated off each asset class. When an MArule 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.


6/22


VBA Simulated Performance


7/22

1.Benchmark Performance2.VBA & Index Performance

a)SP500b)EAFEc)EEMd)REITe)LTR

3.VBA & Core 5 Performance


Outline


8/22


Benchmark Statistics (3/1/1986-8/31/2012)

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

SP500 LTR

CAGR 9.79% 8.63%

Standard Deviation 15.73% 6.52%

Downside Deviation 12.07% 3.81%

Sharpe Ratio 0.39 0.61Sortino Ratio (MAR=5%) 0.47 0.92

Worst Drawdown -50.21% -9.27%

Worst Month Return -21.58% -5.71%

Best Month Return 13.52% 8.73%

Profitable Months 63.21% 67.61%


The typical story: decent returns, but scary drawdowns.

Summary Statistics* EAFE REIT EEM Core 5 EW

CAGR 6.92% 10.55% 12.40% 10.51%

Standard Deviation 18.24% 18.52% 24.61% 12.68%

Downside Deviation (MAR=5%) 12.66% 15.81% 18.82% 10.67%

Sharpe Ratio 0.25 0.43 0.45 0.55

Sortino Ratio (MAR=5%) 0.27 0.43 0.52 0.55

Worst Drawdown -56.68% -68.30% -61.44% -47.21%

Worst Month Return -20.18% -31.67% -28.91% -19.43%

Best Month Return 15.58% 31.02% 18.98% 13.48%

Profitable Months 58.81% 59.75% 61.64% 67.30%


9/22

Summary Statistics* VBA_SP500 Vol Regime_VIX(10,30)_SP500 MA(2,12)_SP500 SP500

CAGR 9.91% 10.60% 10.01% 9.79%



Sharpe Ratio 0.79 0.66 0.54 0.45

Sortino Ratio (MAR=5%) 1.00 0.72 0.56 0.48Worst Drawdown -8.32% -26.21% -29.58% -50.21%




Rolling 5-Y ear Win % -- 44.02% 30.89% 48.65%

Rolling 10-Year Win % -- 65.83% 17.59% 42.71%

DrawDown Total -1418.27% -3671.68% -3382.63% -7131.59%Correation -- 0.732 0.602 0.474

*Returns start in 03/1986 for this strategy.


VBA S&P 500 Summary Statistics


The volatility regime indicator works; VBAvolatility regime & MA signalwork

better.

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

Asset Pricing Model Alpha (annual) Rm-rf SMB HML MOM LQDCAPM 0.05 0.21

p-value*** 0.0005 0.0000

3 Factor (FF) 0.05 0.21 -0.09 -0.07

p-value*** 0.0002 0.0000 0.0181 0.0721

4 Factor 0.04 0.24 -0.10 -0.04 0.09p-value*** 0.0022 0.0000 0.0192 0.2496 0.0005

5 Factor 0.04 0.24 -0.10 -0.05 0.09 -0.07

p-value*** 0.0008 0.0000 0.0136 0.1896 0.0007 0.0525

***Italics denotes p-values significant at the 5% level; robust p-values


10/22

Summary Statistics* VBA_EAFE Vol Regime_VIX(10,30)_EAFE MA(2,12)_EAFE EAFE

CAGR 8.12% 9.86% 6.87% 6.92%



Sharpe Ratio 0.49 0.50 0.31 0.27





Rolling 5-Y ear Win % -- 40.15% 57.53% 50.97%

Rolling 10-Year Win % -- 30.15% 90.95% 69.85%




VBA EAFE Summary Statistics



better.

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


p-value*** 0.0372 0.0000

3 Factor (FF) 0.04 0.13 0.02 0.00

p-value*** 0.0360 0.0001 0.5435 0.9240

4 Factor 0.03 0.15 0.02 0.02 0.08p-value*** 0.0992 0.0001 0.6127 0.6298 0.0019

5 Factor 0.03 0.15 0.01 0.02 0.08 -0.05

p-value*** 0.0724 0.0001 0.7022 0.7280 0.0021 0.1798



11/22

Summary Statistics* VBA_EEM Vol Regime_VIX(10,30)_EEM MA(2,12)_EEM EEM

CAGR 13.49% 15.18% 13.54% 12.40%



Sharpe Ratio 0.78 0.69 0.60 0.46





Rolling 5-Y ear Win % -- 49.03% 39.00% 47.88%

Rolling 10-Year Win % -- 62.81% 32.66% 71.36%




VBA EEM Summary Statistics



better.

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


p-value*** 0.0003 0.0000

3 Factor (FF) 0.08 0.16 0.12 0.05

p-value*** 0.0004 0.0001 0.0655 0.4738

4 Factor 0.08 0.18 0.11 0.07 0.06p-value*** 0.0010 0.0001 0.0821 0.2547 0.1056

5 Factor 0.07 0.18 0.12 0.07 0.06 0.04

p-value*** 0.0020 0.0001 0.0739 0.2310 0.1061 0.3939



12/22

Summary Statistics* VBA_REIT Vol Regime_VIX(10,30)_REIT MA(2,12)_REIT REIT

CAGR 10.40% 12.64% 11.01% 10.55%



Sharpe Ratio 0.75 0.73 0.63 0.44





Rolling 5-Y ear Win % -- 37.07% 33.98% 42.47%

Rolling 10-Year Win % -- 42.21% 24.62% 31.66%




VBA REIT Summary Statistics



better.

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


p-value*** 0.0007 0.0000

3 Factor (FF) 0.05 0.12 0.14 0.13

p-value*** 0.0014 0.0003 0.0006 0.0073

4 Factor 0.05 0.13 0.14 0.13 0.02p-value*** 0.0017 0.0002 0.0008 0.0063 0.4456

5 Factor 0.05 0.13 0.14 0.14 0.02 0.02

p-value*** 0.0022 0.0002 0.0008 0.0061 0.4498 0.5620



13/22

Summary Statistics* VBA_LTR Vol Regime_VIX(10,30)_LTR MA(2,12)_LTR LTR

CAGR 5.73% 6.13% 8.05% 8.63%



Sharpe Ratio 0.43 0.50 0.67 0.72





Rolling 5-Y ear Win % -- 20.85% 8.11% 5.79%

Rolling 10-Year Win % -- 2.01% 2.01% 0.00%




VBA LTR Summary Statistics


VBA, the volatility regime only, and MA rulesdont work in the context of long-bonds.

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

Asset Pricing Model Alpha (annual) Rm-rf SMB HML MOM LQD

CAPM 0.01 -0.01

p-value** 0.1200 0.5131

3 Factor (FF) 0.01 0.00 -0.04 0.02

p-value** 0.1279 0.9542 0.2101 0.4846

4 Factor 0.01 0.01 -0.04 0.02 0.02

p-value** 0.2080 0.5966 0.1743 0.2960 0.1557

5 Factor 0.01 0.01 -0.04 0.02 0.02 0.00

p-value** 0.1867 0.6020 0.1767 0.3168 0.1555 0.8280


14/22

Summary Statistics* VBA_Core 5 EW Vol Regime Only_Core 5 EW Core 5 EW_MA Core 5 EW

CAGR 9.76% 11.26% 10.37% 10.51%



Sharpe Ratio 1.07 0.88 0.77 0.55





Rolling 5-Y ear Win % -- 30.50% 27.80% 47.49%

Rolling 10-Year Win % -- 44.22% 15.58% 49.75%




VBA Summary Statistics



better.

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


p-value*** 0.0000 0.0000

3 Factor (FF) 0.05 0.12 0.03 0.03

p-value*** 0.0000 0.0000 0.1994 0.3362

4 Factor 0.04 0.14 0.03 0.05 0.06p-value*** 0.0000 0.0000 0.2689 0.0606 0.0006

5 Factor 0.04 0.14 0.03 0.04 0.06 -0.01

p-value*** 0.0000 0.0000 0.2934 0.0760 0.0007 0.5697



15/22


Annual Returns (3/1/1986-8/31/2012)


2008 is the only negative annual return.

VBA_Core 5 EW Vol Regime Only_Core 5 EW Core 5 EW_MA Core 5 EW

1986 6.24% 6.40% 16.22% 16.41%

1987 26.14% 34.69% 3.04% 11.29%

1988 13.58% 21.18% 13.64% 21.68%

1989 19.29% 22.01% 23.49% 26.28%

1990 5.97% 7.88% -4.23% -8.46%

1991 6.68% 11.54% 19.34% 30.95%

1992 3.77% 4.28% 6.58% 6.05%

1993 10.77% 11.67% 25.74% 28.88%

1994 10.72% 10.94% 0.19% 0.48%

1995 14.89% 14.53% 17.14% 15.90%

1996 3.78% 4.16% 11.72% 14.19%

1997 8.09% 4.87% 13.32% 10.45%

1998 10.12% 15.47% 5.61% 2.90%1999 16.73% 19.17% 17.70% 19.33%

2000 9.37% 4.84% 2.39% -3.51%

2001 5.80% 1.98% 6.63% -2.78%

2002 4.08% -2.93% -0.81% -4.81%

2003 12.81% 24.65% 23.43% 32.11%

2004 16.13% 16.13% 18.71% 18.92%

2005 1.52% 1.69% 13.39% 13.58%

2006 24.35% 24.44% 22.47% 22.46%

2007 17.18% 18.27% 10.81% 9.90%

2008 -8.08% -19.06% -2.94% -32.41%

2009 9.72% 29.50% 15.57% 31.77%

2010 7.38% 10.92% 8.65% 16.08%

2011 4.03% 1.61% -2.59% -1.57%

2012_YTD 3.66% 12.27% -0.77% 10.03%


16/22


Invested Growth (3/1/1986-8/31/2012)



17/22


Market Cycle Performance (3/1/1986-8/31/2012)

VBA controls risk during bear markets and participates in bull markets.



18/22


Rolling CAGR Analysis (3/1/1986-8/31/2012)


VBA delivers consistent results.


19/22


Drawdown Analysis (3/1/1986-8/31/2012)


VBA controls risk; 36-month drawdowns are positive


20/22


ST Stress Test Analysis (3/1/1986-8/31/2012)


VBA is not affected by major market stress events.


21/22


Rolling Drawdown Analysis (3/1/1986-8/31/2012)


VBA consistently controls risk; Core5 EW strains during the 2008 Financial Crisis as correlations go to 1.


22/22


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 notconstitute 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 andissuers 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 oraccuracy, 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 performanceis 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 shouldcarefully consider their financial position and risk tolerance to determine if the proposed trading style is appropriate. Investors should realize that whentrading futures, commodities and/or granting/writing options onecould lose the full balance of their account. It is also possible to lose more than the initialdeposit 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 arefrequently sharp differences between hypothetical performance results and the actual results subsequently realized by any particular trading program. Oneof the limitations of hypothetical performance results is that they are generally prepared with the benefit of hindsight. In addition, hypothetical tradingdoes 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 actualtrading results. The hypothetical performance results contained herein represent the application of the quantitative models as currently in effect on the datefirst 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 thefuture will produce similar results because the relevant market and economic conditions that prevailed during the hypothetical performance period will notnecessarily recur. There are numerous other factors related to the markets in general or to the implementation of any specific trading program whichcannot be fully accounted for in the preparation of hypothetical performance results, all of which can adversely affect actual trading results. Hypotheticalperformance 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 inhigher or lower than expected.

Volatility Asset Management

Documents

Transcript of Volatility Asset Management