Universal Investment Strategy

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Universal Investment Strategy 2017-04-20T02:13:05+00:00

Project Description

The SPY-TLT Universal Investment Strategy (UIS) is one of our new core investment strategies. Probably the most basic of all rotation strategies, is the switching strategy between the S&P 500 US stock market (SPY) and long duration Treasuries (TLT). The SPY-TLT ETF pair is very interesting, because most of the time these two ETFs profit from an inverse correlation. If there is a real stock market correction, then Treasuries like TLT have always been the assets where money flows in, rewarding holders with nice profits.

December 2016 Update: Our U.S. based Universal Investment Strategy UIS will have a hedge that can now choose between TLT and TIP. TIP is a very liquid inflation protected Treasury. TIP is less volatile than TLT and is a good alternative when TLT is heading lower. More details here.

A variable allocation between stock market ETFs and Treasuries has by far the best risk/return (Sharpe) ratio. Fixed ratios do only perform well when market conditions do not change. So be sceptic if somebody will sell you a strategy with a fixed allocation which is only backtested for the last few bull market years. Normally these strategies will fail in when the next 2008 like bear market begins. The SPY-TLT rotation has a slightly higher return, but a much higher volatility or risk. Return alone should never be used to judge a strategy. In fact it is very simple to boost the return by using leveraged ETF replacements for SPY and TLT. But this would in no way make the strategy superior, because then also the volatility or risk will be higher by the leverage factor.

December 2016 Update: Our U.S. based Universal Investment Strategy UIS will have a hedge that can now choose between TLT and TIP. TIP is a very liquid inflation protected Treasury. TIP is less volatile than TLT and is a good alternative when TLT is heading lower.

Research is undertaken to ensure that the diversified mix of asset classes is appropriate for the desired level of risk. Specific ETFs are screened and chosen to best represent the asset class, while also maintaining low management fees and index tracking error.

The 2 ETF used in this strategy are:

  • US Market (SPY – SPDR S&P 500 ETF)

and the best risk-adjusted performer from:

  • Long Duration Treasuries(TLT – iShares 20+ Year Treasury Bond)
  • Inflation Protected Treasuries (TIP – iShares Trust – iShares TIPS Bond ETF)



Risk and Performance Profile

Risk Score:?
Performance:
3 Months12 MonthsSince Inception
Return
CAGR
Volatility
DrawDown
Sharpe
Annual Performance vs. Benchmark

Probably the most basic of all rotation strategies, is the switching strategy between the S&P 500 US stock market (SPY) and long duration Treasuries (TLT). The SPY-TLT ETF pair is very interesting, because most of the time these two ETFs profit from an inverse correlation. If there is a real stock market correction, then Treasuries like TLT have always been the assets where money flows in, rewarding holders with nice profits.

Now there are two possibilities to profit from this inverse correlation. The first is a switching strategy, which always switches to the ETF which had the best performance during the previous 3 months. This really simple switching strategy between TLT and SPY gave you a 14.8% return during the last 10 years, with twice the Sharpe ratio (return to risk) ratio of a simple SPY investment.

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Another strategy would be to invest 50% of your money in SPY and 50% in TLT and do a monthly rebalancing. This gave you 8.8% return during the last 10 years.

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Now let’s see, how these two strategies performed the first 10 month of 2014. For quite some time we now had a sort of a sideways market. Conflicts like Syria or Ukraine made investors switch several times in “risk off” mode which favors safe haven assets like our TLT Treasury, but shortly after they switched back to “risk on” mode favoring our SPY stock market ETF. Such whipsaw market is bad for rotation strategies and as a result our SPY-TLT switching strategy only made 5.6% during the first 10 months with a Sharpe ratio of 0.59.

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This time the much better strategy was to hold equal positions of SPY and TLT. This strategy made 16.7% during the first 10 months with an very high Sharpe ratio of 3.12.

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If you analyze these two strategies, then you will quickly see which are the advantages and disadvantages of each strategy. The switching strategy did well during market periods with a strong up or down trend. In 2008 this strategy could avoid the stock market crash by switching nearly 100% to Treasuries. During sideways market periods and especially during whipsaw market periods, the switching strategy switched a lot of times too late, which resulted in an unwanted sell low and buy high strategy.

The idea for this Universal Investment Strategy was to develop a strategy which has an adaptive allocation between 0% and 100% for each ETF depending of the market situation. I am using such a strategy for quite some time with excellent results. Since 2014 the strategy invests always approximately equal parts of TLT and SPY.

The way to calculate the optimum composition is done by calculating which composition had the maximum Sharpe ratio during an optimized look back period (normally 50-80 days). During normal market periods, the maximum Sharpe ratio is not at a 100% SPY or at a 100% TLT allocation, but somewhere in between. To calculate this maximum Sharpe ratio, I loop through all possible compositions from 0%SPY-100%TLT to 100%SPY-0%TLT and calculate the resulting Sharpe ratio for the look back period.

As a result I get a curve like this (result of July 21, 2014):

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The interesting finding is, that the best combination of SPY-TLT gets with 5.27 a considerably higher Sharpe ratio then SPY (3.38) or TLT (2.01) alone. This is because the inverse correlation of the two ETFs reduces volatility or risk a lot.

On July 21, 2014 when I made this calculation, this would mean that the optimum composition for the portfolio would be 60% SPY and 40% TLT. This composition is in this case also the one with the lowest volatility.

Year to date the volatility of such a strategy is below 5%, which is less than half the volatility of SPY or 3x to 4x less compared to other markets (Europe, Emerging markets).

For my UIS strategy I tweaked the Sharpe formula a little bit. Normally the Sharpe ratio is calculated by Sharpe = rd/sd with rd=mean daily return and sd= standard deviation of daily returns. I don’t use the risk free rate, as I only use the Sharpe ratio to do a ranking. My algorithm uses the modified Sharpe formula Sharpe = rd/(sd^f) with f=volatility factor. The f factor allows me to change the importance of volatility.

If f=0, then sd^0=1 and the ranking algorithm will choose the composition with the highest performance without considering volatility.

If f=1, then I have the normal Sharpe formula.

If f>1, then I rather want to find SPY-TLT combinations with a low volatility. With high f values, the algorithm becomes a “minimum variance” or “minimum volatility” algorithm.

To get good results, the f factor should normally be higher than 1. This way you do not need to rebalance too much. In a whipsaw market, rebalancing also has the negative effect of selling low and buying high on small intermediate market corrections. This is why a system which considers only performance will not do well.

The good f factor for a system can be found by “walk forward” optimization iterations of your backtests. Normally a good value for f is about 2, but the factor changes slightly, adapting to the current market conditions.

Comparison of different SPY-TLT strategies:

Strategy5 year CAGRSharpe ratio
1SPY-TLT UIS adaptive allocation18% annual return1.66
250% SPY- 50% TLT rebalanced monthly12.5% annual return1.31
3SPY – TLT monthly rotation strategy19% annual return1.19

It is interesting to see, that the return of such a strategy will be higher if market volatility is higher. So, for the low volatility period from 2000-2007 (SPY volatility of 13), the annual return was about 9%, but since then, we had an average SPY volatility of 23, which results in a much higher return for the strategy. So this means, that with such a strategy we are happy if we have a really nice 25% market correction followed by a recovery, because this means, that we can profit from the market corrections by over-weighting TLT and later on, we profit again from the recovery by over-weighting SPY.

So, in summary, a variable allocation between stock market ETFs and Treasuries has by far the best risk/return (Sharpe) ratio. Fixed ratios do only perform well, when market conditions do not change. Be skeptical if somebody will sell you a strategy with a fixed allocation which is only backtested for the last few bull market years. Normally these strategies will fail when the next 2008 like bear market begins. The older methodology SPY-TLT rotation has a slightly higher return, but a much higher volatility or risk. Return alone should never be used to judge a strategy. In fact it is very simple to boost the return by using leveraged ETF replacements for SPY and TLT. But this would in no way make the strategy superior, because then also the volatility or risk will be higher by the leverage factor.

Here is a plot of the results if you use short positions of the -3x leveraged SPXS-TMV instead of SPY-TLT. The result is incredible. 2051% return for the 5.5 year period. This is a 74% annual return with a Sharpe ratio of 2.6. In the below chart, you see also a green chart which shows you the monthly SPXS allocation. The TMV allocation is always the 100%- SPXS allocation. It is interesting to see, that even if we had a bull market during this period, in average the strategy is about 50% invested in Treasuries.

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For further Investment strategies derived from the UIS allocation see our whitepaper and blog post.