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Frank, Alex, comments from my blog post replicating/investigating this strategy:
“Hi Ilya,
Thanks for the post and nice job with the blog!
The missing piece is the tax rate applied to dividend. This seriously reduces the real amount available to investors. Worst case scenario is a foreign investor (like me) who has to pay a 30% tax on dividend: that changes dramatically the all picture. The rate applied to US resident is very different but it’s not nugatory either from memory.The R Trader”
and this one (from Gerald M):
“I ran a bond rotation strategy for about 5 months last year. Being a foreign investor (like R Trader), it wasn’t worth it due to taxes. You are correct that dividends are a substantial portion of returns but if you have to pay significant taxes (or even regular taxes), the risk/reward changes – and not in a positive way! It would be interesting to try this on a quarterly basis using mutual funds. But as you have pointed out, the gap between closed and adjusted (not really achievable) is huge. I expect that to hold on a quarterly time frame.
Regarding those ratios, when using MF data back in the 90’s or pre 2007 for that matter, I think you should look at the risk free yields and not use RF=0%. From 1995 through to 2000, for example, 90 day yields were 5%. If you look at the return of these rotation strategies against a 5% RF yield, they will not look anywhere near as attractive. If you factor in inflation and then calculate the real returns, well, it gets worse. The 90 day monthly rates from 1934 are here: http://bit.ly/1IuEB9V
Finally, the post-2008 periods saw the Fed quadruple their balance sheet thereby lifting equity prices and bond yields got crushed at the same time (and of course the last 30 years saw the biggest bond bull ever on top of all that). So it was quite a distortion that was introduced in the markets (unprecedented in fact). You can see the effect of this intervention in your graphs above. There is a significant inflection point post 2008 (the same goes for the Universal Strategy). So the strategy is a curve fit because it is what worked well given the monetary policy. Walk-forward techniques don’t prevent curve fitting if the underlying strategy itself is a curve fit. It’s simply trying to optimize and already fitted algorithm. Going forward, I don’t expect interest rates to drop another 6% or more from here or for the Fed to quadruple their balance sheet again with QE5-8 thereby lifting prices through ten’s of billions of monthly purchases. CWB has a 60 day correlation of daily returns of 0.8 to the SP500. That’s very high so it’s like owning an equity index (although I haven’t tried it, I would not be at all surprised if you substitute SPY for CWB and get a similar result).
So basically, reality bites. Dividend taxes, inefficiencies in dividend reinvestment, trading fees, inflation, risk-free rates prior to 2007 and the curve-fit gains post 2008 makes me highly skeptical that this will actually yield any alpha going forward.”
Care to respond?
Compared to the Universal Investment Strategy, which I’ve been able to get a ballpark replica on, these rules are far more opaque. What’s the specific historical volatility threshold? How do you adjust the weights? Regarding momentum, what’s the lookback period you use to measure it? How do you adjust your weights in light of that? What about mean reversion? One month lookback? How much do you sell that security off compared to its default 1/7th holding?
Even with the 200-day SMA, well, okay, if the asset is below its 200-day SMA, do you simply not invest in it and reallocate its weight among the rest of the securities?
In short, while the base idea is easy enough (rebalance an equally-weighted portfolio monthly), the innovations are very opaque. Care to clarify, as with the Universal Investment Strategy, so that I may be able to get in the ballpark to corroborate these results?
Thanks!
