Transcription

• Speaker #0

  Hello, welcome back to Papers with Backdesk podcast. Today we dive into another algo trading research paper. It's all about this, well, it's called paired switching. You know how we're always talking about diversification and finding assets that zig when others zag? Well, this strategy just kind of takes that idea and runs with it.

• Speaker #1

  Yeah, it's a really clever approach. Instead of just holding like a static mix of those negatively correlated assets, paired switching is like, hey, let's actively exploit these ups and downs. So when one asset is doing better, you shift your investment toward it. And then when the tide turns, you switch to the other one. It's almost like trying to ride the waves of the market movements instead of just bobbing along.

• Speaker #0

  So instead of just diversifying and hoping for the best, you're making strategic moves based on recent performance. It sounds pretty intuitive, right? Yeah. But the research paper we're looking at today really takes us a step further and actually puts this strategy to the test. And you know me, I love a good back.

• Speaker #1

  Well, they used a really straightforward example to illustrate the concept. They took two Vanguard funds, VFINX, which tracks the S&P 500, and VUSTX, a long-term government bond fund. You can think of these as like classic examples of negatively correlated assets. When stocks are doing well, bonds often take a backseat and vice versa.

• Speaker #0

  Okay. So we got our asset pair, VFINX and VUSTX. Now what are the actual trading rules? How do we decide when to switch?

• Speaker #1

  So the beauty of this strategy is its simplicity. You look back at the performance of each fund over the previous quarter. Whichever one performed better, that's where you put your money. You hold it for a quarter. Then you reevaluate and potentially switch again based on the previous quarter's performance. Rinse and repeat. No fancy algorithms or indicators. Just a simple performance comparison.

• Speaker #0

  I love it. It's like the buy what's hot, sell what's not approach. Yeah. But applied systematically. And the paper actually back-tested this strategy with real historical data. What did they find?

• Speaker #1

  Well, the results were pretty interesting. When they applied the paired switching to VFNX and VUSTX over a 20-year period from 1991 to 2011, they found that it consistently outperformed just holding either fund individually. Now, the high performance wasn't massive, but it was statistically significant, meaning it wasn't just random luck.

• Speaker #0

  Statistically significant. I like the sound of that. That means there's a good chance this strategy wasn't just a fluke. It actually has the potential to add some real value. But hold on. Wasn't that backtest period? Kind of. Well, ancient history. What about more recent market conditions?

• Speaker #1

  That's a good point. The researchers also backtested the strategy using more recent data, from 2003 to 2011. But this time they paired different ETFs, SPY, EFA, and VTI with TLT, a long-term treasury ETF. And guess what? The results were even more impressive. They saw substantial improvement in returns and reduced volatility, compared to just holding the ETFs individually. Okay.

• Speaker #0

  Now that's getting me excited. So we're seeing promising results. both in the longer term backtest and the more recent one, using different asset pairs. It's starting to feel like this paired switching idea might actually have some legs.

• Speaker #1

  Yeah, it definitely seems that way. But here's where it gets even more interesting. The researchers didn't stop at just testing individual asset pairs. They applied this paired switching approach to some of those, well, you always hear about them, lazy portfolios.

• Speaker #0

  Lazy portfolios, you mean those set it and forget it asset allocations that are supposed to be good for... Long-term hands-off investing.

• Speaker #1

  Exactly. Think of portfolios like the classic 60-40 stock bond mix, the Andrew Tobias three-fund portfolio, and even more sophisticated ones like the Swenson and Bernstein basic portfolios.

• Speaker #0

  So they took these lazy portfolios, which are already considered fairly well diversified, and applied the paired switching strategy on top of that. I'm on the edge of my seat here. What happened?

• Speaker #1

  Well, across the board. Paired switching consistently either boosted returns or reduced volatility. Sometimes even both. It's like they took these already solid portfolios and gave them a performance tune-up.

• Speaker #0

  Wow, that's pretty impressive. It really makes you wonder if those set-it-and-forget-it portfolios might actually benefit from a little bit of active management, at least in the context of paired switching.

• Speaker #1

  Yeah, it's a compelling thought, isn't it? But before you rush out and start rejigging your entire portfolio, let's take a step back and consider a few important caveats. First, remember that backtesting is based on historical data. And as we all know, past performance is never a guarantee of future results.

• Speaker #0

  Right. The markets have a way of throwing curveballs when you least expect them.

• Speaker #1

  Exactly. And second, the research paper didn't take into account transaction costs, which can be a real drag on your returns, especially if you're switching between assets frequently.

• Speaker #0

  That's a crucial point. If you're paying like a commission every time you buy or sell, those costs can really eat into your profits. So while the backtest results are exciting, it's important to approach this strategy with a healthy dose of realism.

• Speaker #1

  Absolutely. This isn't some magic bullet, and it's not a risk-free strategy. But it does raise some really intriguing questions. For example, the research mainly focused on stocks and bonds. What about other asset classes? Could you apply paired switching to real estate versus commodities or gold versus Bitcoin? I mean, the possibilities are vast.

• Speaker #0

  That's a fascinating thought. Imagine being able to strategically shift between different asset classes. Based on their recent performance, it could potentially open up a whole new level of portfolio optimization. And it makes you think about those correlations again, right? You wouldn't want to pair two assets that tend to move in the same direction, like two different tech stocks. You need that negative correlation. That push and pull to potentially capture gains on one side while minimizing losses on the other.

• Speaker #1

  Precisely. Choosing the right asset pairs is critical to making the strategy work. And that leads to another important question. How often should you switch? Switching too frequently could lead to excessive transaction costs, while switching too infrequently might cause you to miss out on potential gains. Finding that sweet spot, that optimal switching frequency is key.

• Speaker #0

  Yeah, it sounds like there's a lot more to explore here. While the research paper provides like a solid foundation, there are still like many open questions and nuances to consider. It's almost like this paired switching idea. It's just the tip of the iceberg.

• Speaker #1

  Yeah, it is. And that's what makes it so exciting. This research challenges conventional thinking about diversification and portfolio construction. It encourages us to look beyond static allocations and consider the power of dynamic strategies. And who knows, maybe this conversation will spark an idea for our listeners. To develop their own variations of paired switching, tailored to their own specific goals and risk tolerance.

• Speaker #0

  I love that. We're not just giving our listeners the answers, we're giving them the tools and inspiration to ask their own questions. Yeah. And come up with their own innovative trading strategies.

• Speaker #1

  Exactly. Trading is a journey of continuous learning and exploration. And this paired switching concept is a great example of how a relatively simple idea can potentially lead to significant improvements in your portfolio's performance. But remember. no trading strategy, no matter how promising, is without risks.

• Speaker #0

  Right. There's always the risk of being whipsawed by the market. Imagine switching into an asset right before it starts to underperform or out of an asset right before it takes off. Timing is everything.

• Speaker #1

  Absolutely. And that brings us back to those caveats we discussed earlier. Backtesting can be a great tool, but it's not a crystal ball. And real world market conditions can be a lot messier than what we see in those neat historical charts.

• Speaker #0

  So while this research gives us some really valuable insights and food for thought, it's important to approach it with a healthy dose of skepticism and to do your own due diligence before implementing any new strategy.

• Speaker #1

  Couldn't agree more. Trading is a game of probabilities, not guarantees. But that doesn't mean we can't learn from research and explore new ideas. In fact, that's what keeps trading exciting and challenging.

• Speaker #0

  It certainly does. And speaking of exciting and challenging, we've covered a lot of ground today. But before we wrap up this deep dive, I want to make sure our listeners know where they can find more information about this paired switching strategy.

• Speaker #1

  Of course. You can find the full research paper along with all the backtest results and our own analysis on our website, paperswithbacktest.com. We've also got a ton of other resources there, including deep dives into other fascinating algo trading strategies.

• Speaker #0

  So if you're intrigued by this paired switching idea and you want to dig deeper, head over to paperswithbacktest.com. You might just discover your next trading edge.

• Speaker #1

  And hey, while you're there, check out our other episodes. We've got a whole library of deep dives covering all sorts of fascinating algo trading strategies. We're always on the lookout for cutting edge research that can help you level up your trading game.

• Speaker #0

  We're firm believers that knowledge is power, especially in the world of finance. And we're passionate about making complex research accessible and actionable for traders of all levels, whether you're just starting out or you're a seasoned pro.

• Speaker #1

  So join us on this journey of discovery as we unlock the secrets of successful algo trading together.

• Speaker #0

  Thank you for tuning in to Papers with Backtest podcast. We hope today's episode gave you some useful insights. Join us next time as we break down more research. And for more papers and backtests, find us at paperswithbacktest.com. Happy trading.