Backtesting Tactical Asset Allocation

Build a dynamic asset allocation strategy and backtest results

How to Backtest Tactical Asset Allocation

Unveiling Dynamic Asset Allocation Strategies

Tactical asset allocation backtesting is a quantitative technique used by investors and portfolio managers to evaluate the historical performance of a dynamic asset allocation strategy over time. Unlike a static asset allocation, which maintains a fixed allocation to different asset classes, a tactical asset allocation strategy flexibly adjusts asset selection and allocation weights over time in response to changes in the economic environment or investor preferences. Momentum is most commonly used to define these preferences. Momentum reflects investor sentiment and reacts to market price movements, which can help avoid large losses.

Embracing Momentum: A Key to Success

At the heart of tactical (dynamic) asset allocation lies the concept of momentum—a powerful force that drives market movements. Momentum strategies capitalize on the tendency of assets to maintain their trajectory over time, allowing investors to ride the wave of upward trends while mitigating risks during downturns.

Exploring Allocation Methods

Tactical (dynamic) asset allocation presents a range of allocation methods, each tailored to meet specific investment objectives:

• Equal Weight: Distributes investments evenly among selected assets, promoting balance and diversification.

• Inverse Volatility: Adjusts asset weights based on historical volatility, aiming to minimize risk and maximize returns. Example: If the risk (volatility) of a bond is 10 and the risk (volatility) of an equity is 30, the allocation will be 1/10 in bonds and 1/30 in equities, with a corresponding weighting of 25% in equities and 75% in bonds for a total of 4/30. This inverse volatility allocation method produces almost identical results to the risk parity method and has the advantage of being much simpler to calculate.

• Minimum Variance: Seeks to minimize portfolio risk by optimizing asset allocations, drawing on Markowitz's modern portfolio theory.

Offensive Asset Universe: Navigating Selection Criteria

Tactical (Dynamic) asset allocation begins with the identification of offensive assets—those poised for growth. Selection criteria include:

• Relative Momentum: Identifies assets with strong relative performance compared to peers.

• Absolute Momentum: Evaluates assets based on their individual historical performance.

To calculate each of these, you need to decide whether you want to use returns, a moving average or a multi-period momentum score, and select a base period for the momentum calculation.

Allocation Options

The selection of investments is driven by data that changes every month. This is where we set the rules for how the selected assets will be allocated.

First you decide how the portfolio itself will be allocated (equal weight, inverse volatility, minimum variance) and then you decide on a range of offensive assets. If you don't decide on a range, you will invest 100% in offensive assets.

• Fixed range: You can fix the maximum value of the offensive asset weight (e.g. you can limit the risky assets - offensive assets)

• No. of Negative Absolute Momentum: If the number of negative absolute momentum assets among the candidate assets is greater than or equal to n, the entire portfolio is shifted to defensive assets.

• No. of Positive Absolute Momentum: The investment portfolio is weighted by the percentage of positive absolute momentum assets among the investment candidates (e.g. if only 2 out of 3 investment candidates are positive absolute momentum, the offensive assets will have 66% of the portfolio weight).

• Maximum Volatility Restircition: The volatility of the investment portfolio is first calculated and then the weights are flexibly adjusted by adding cash to limit the overall volatility below a certain level.

• Seasonality: For the selected month, the portfolio will be composed of defensive assets. (e.g., Halloween strategy)

Crash Protection Option A - Canary ETF

In addition to the existing conditions, we offer a Crash protection (A) - the so-called "Canary" option - as a risk management tool. It aims to respond more quickly to crises in global markets by selecting specific ETFs with a particular movement.

You can choose a separate ETF or an ETF that is already known to have a leading move. We also offer a relative momentum function that determines the comparative advantage by selecting an ETF that is comparable to the one based on absolute momentum.

• Defensive option: If you select two canaries, the default is to switch to 100% defensive assets if two conditions are met, and to 50% defensive assets if only one condition is met. If you select the defensive option, it will switch to 100% defensive if only one of the two conditions is met.

• Neutral option: Defensive asset % = Negative Canary / Total Canary

• Offensive option: If all canaries signaled, switch 100% to defensive assets

Crash Protection Option B - Market Data

Not often, but from time to time, for as short as a year or as long as several years, there are anomalies in the economic environment that deviate significantly from the norm. In these cases, it may be better to take a break from investing and hold cash to avoid extreme crises.

• Option 1: Inverted Yield Curve (10-year minus 2-year) - Move into Defensive Assets if the 10-year minus 2-year yield turned negative from A to B months ago

• Option 2: Inverted Yield Curve (10-year minus 3-month) - Move into Defensive Assets if the 10-year minus 3-month yield turned negative from A to B months ago

• Option 3: S&P500 Dividend Yield - When the dividend yield on the S&P500 falls below certain levels, move into Defensive Assets.

• Option 4: Unemployment rate (general) - hedges against recession by assuming that the unemployment rate has risen above a certain threshold.

• Option 5: Unemployment Rate & Spy (GTT-UE) - This option is used in the GTT-UE strategy and is triggered when the unemployment rate is above the previous 12-month average and the SPY is below its 10-month moving average.

• Option 6: Sahm's Rule - When the 3-month moving average of the U.S. unemployment rate is at least 0.5% points above the previous 12-month minimum and has increased from the previous month, move into defensive assets.

• Option 7: Sahm's Rule and SPY Momentum - Move to defensive assets when the 3-month moving average of the U.S. unemployment rate is 0.5% points above the prior 12-month minimum & the SPY is below its 10-month moving average

Select Defensive Asset

A defensive asset is an asset that can be used as a defence when an offensive asset is not selected. A typical example would be cash.

We've also included a selection of fixed income assets, which are relatively stable, because even the average institutional investor will often hold short-term bonds as an alternative to cash in order to get a little yield rather than just taking cash.

In addition, we also give you the opportunity to consider better choices through momentum indicators.

• Defensive asset universe: We typically use cash as the defensive asset, but you can choose from a variety of assets. Multiple selections are possible.

• Relative Momentum: Select a target asset from the selected defensive asset universe in order of relative return.

• Absolute Momentum Cash Switch: Switch to cash if the selected defensive universe has negative absolute momentum.

Conclusion: Charting a Course for Success

Incorporating dynamic asset allocation strategies into your investment approach can open up a world of opportunity and allow you to navigate market fluctuations with confidence. By harnessing momentum, optimizing allocations, and fortifying portfolios with defensive assets, you can build complex portfolios to meet your long-term financial goals without the use of coding or Excel.