Transcription

• Speaker #0

  Hello. Welcome back to Papers with Backtest podcast. Today, we're diving into another algo trading research paper.

• Speaker #1

  Another one,

• Speaker #0

  yeah. It's called Protective Asset Allocation, PAA, a simple momentum-based alternative for term deposits.

• Speaker #1

  Catchy.

• Speaker #0

  By Wooter J. Keller and Jan Willem Kuehning.

• Speaker #1

  Those names sound familiar. Have we covered any of their work before?

• Speaker #0

  I don't think so, but you know, sometimes you just want a safe place to park your money, like a term deposit.

• Speaker #1

  Right,

• Speaker #0

  right. But what if there was a way to get, like, potentially better returns.

• Speaker #1

  Of course, who wouldn't want that?

• Speaker #0

  Without taking on a huge amount of risk.

• Speaker #1

  Yeah, the dream, right. Low risk, high reward.

• Speaker #0

  That's exactly what this paper explores.

• Speaker #1

  Really? That sounds pretty interesting. So how do they approach that?

• Speaker #0

  Well, they introduced this concept called protective asset allocation or PAA.

• Speaker #1

  PAA, okay.

• Speaker #0

  Which essentially acts like a dynamic portfolio that adjusts itself based on how the market is doing.

• Speaker #1

  Interesting. So it's not just a set it and forget it kind of strategy.

• Speaker #0

  Right. Yeah. Yeah. It actually reacts to what's happening in the markets.

• Speaker #1

  So how does it do that? Like what's the secret sauce?

• Speaker #0

  Well, think of it like a 60-40 portfolio on steroids.

• Speaker #1

  Okay. I'm intrigued. A 60-40 on steroids, what does that even mean?

• Speaker #0

  So instead of just stocks and bonds, you've got a whole global multi-asset universe to play with.

• Speaker #1

  Oh, I see. So they're branching out beyond just the traditional stocks and bonds.

• Speaker #0

  Right. And the really cool part is that the safe asset allocation, which they often use treasury bonds for, actually changes depending on market conditions.

• Speaker #1

  Oh, that's where the protective part comes in, right? It's adjusting that safe haven portion based on what, market volatility?

• Speaker #0

  Exactly, yeah. Like having a built-in shield.

• Speaker #1

  Uh-huh. A shield that gets stronger when things start to get rough in the markets, that's a cool way to put it. But how does it actually know when to raise the shields? Like, what triggers that shift?

• Speaker #0

  Well, the paper uses this This clever thing, a multi-market breadth indicator.

• Speaker #1

  Multi-market breadth indicator. What's that?

• Speaker #0

  So it's essentially a gauge of how many assets in the market are actually showing positive momentum, meaning they're trending upwards.

• Speaker #1

  Ah, so it's measuring the overall market health, how many things are actually going up. Makes sense.

• Speaker #0

  Yeah. So the fewer assets with positive momentum, the more bearish the signal.

• Speaker #1

  Okay. So it's not just looking at individual assets, but taking the pulse of the entire market.

• Speaker #0

  Exactly. Now, this is where it gets really interesting if you're thinking about actually trading this. The paper backtests this strategy using a universe of 12 ETFs.

• Speaker #1

  12 ETFs? Wow, that's a decent number. What kind of ETFs are we talking about?

• Speaker #0

  This covers a wide range of asset classes, including U.S. and international stocks,

• Speaker #1

  real estate,

• Speaker #0

  commodities, gold, and even some bonds.

• Speaker #1

  Okay, so they're really covering a lot of ground with those 12 ETFs.

• Speaker #0

  That sounds like a pretty diversified playground.

• Speaker #1

  Yeah, it does. It covers a long period, too, right? I remember seeing something about the 1970s in there. Yes.

• Speaker #0

  They back-tested the strategy from December 1970 all the way to December 2015. Wow. That's a long time. Which is important because it includes periods of rising interest rates, like the one we saw in the 70s and early 80s.

• Speaker #1

  Right. And those periods can be tricky for some strategies. So it's good they included those.

• Speaker #0

  This helps us see how PAA might perform in different economic environments.

• Speaker #1

  Yeah. Different environments. That's key. Yeah. Because we're obviously in a very different... interest rate environment now than we were back then.

• Speaker #0

  Okay. So they've got this diverse set of assets. They're looking at a long historical period.

• Speaker #1

  Yeah. And the strategy adjusts based on market conditions. Sounds pretty comprehensive so far. But what about the actual trading rules? How does an asset get picked?

• Speaker #0

  Or kicked out, yeah, of the portfolio?

• Speaker #1

  Right. What are the criteria?

• Speaker #0

  They use something called simple moving averages.

• Speaker #1

  SMAs. Ah, good old SMAs.

• Speaker #0

  Or SMAs. which you might be familiar with if you've been following our other deep dives into trend following strategies.

• Speaker #1

  Yeah, we've talked about SMAs a fair bit.

• Speaker #0

  Basically, an SMA is a way to smooth out the price fluctuations of an asset over a certain period of time.

• Speaker #1

  Right, smoothing out the noise, getting a clearer picture of the trend.

• Speaker #0

  If the price is above its SMA, it suggests an upward trend, and that's a good sign for the PAA strategy.

• Speaker #1

  So they're basically riding the wave of upward trends, but I'm guessing they're not just holding on forever, right?

• Speaker #0

  Right. There has to be a point where they say, OK, this wave is crashing. Let's get out.

• Speaker #1

  Exactly. So when do they jump off?

• Speaker #0

  And that's where the specific look back period for the SMA comes in.

• Speaker #1

  Ah, the look back period. Got it.

• Speaker #0

  They tested a few different periods.

• Speaker #1

  OK.

• Speaker #0

  But they found that a 12 month look back seemed to work best.

• Speaker #1

  12 months. So they're looking back over a year.

• Speaker #0

  This means they're looking at whether the price is above its 12 month SMA to signal an uptrend.

• Speaker #1

  Makes sense.

• Speaker #0

  They also have rules for when to exit positions.

• Speaker #1

  Of course, gotta have an exit strategy.

• Speaker #0

  If the price falls below its SMA, it's a signal that the trend might be reversing.

• Speaker #1

  Uh-huh, the trend's changing.

• Speaker #0

  And that's when they would sell that asset.

• Speaker #1

  Okay, so the look-back period is like the timer on their surfboard telling them when it's time to catch a new wave or jump off the old one.

• Speaker #0

  Right, and remember, All of this is happening while that market breadth indicator is keeping an eye on the overall health of the market.

• Speaker #1

  Right, right. That's running in the background the whole time.

• Speaker #0

  And adjusting the allocation to safer assets if needed.

• Speaker #1

  Got it. So it's like a dual momentum system, individual asset momentum, and then that overall market momentum.

• Speaker #0

  They actually tested three different variations of the PAA strategy.

• Speaker #1

  Three variations. OK, so there's some fine tuning going on here.

• Speaker #0

  Each with a different level of protection. They called them PAA Day Zero. PA1 and PA2.

• Speaker #1

  PA0, PA1, PA2. I'm assuming PA2 is the most Ausha one. The one that really dials up the safety when things start looking shaky.

• Speaker #0

  Okay, so we've got the assets, the time period, the trading rules, and even different levels of risk aversion built in.

• Speaker #1

  Yeah, we've laid out the foundation here. What did they find when they actually put this thing to the test? Did it actually work?

• Speaker #0

  Well, the results are pretty interesting. In their in-sample period,

• Speaker #1

  In SAML, so this is the data they used to optimize the strategy.

• Speaker #0

  Which is the data they used to optimize the strategy. The most protective variant, PAA2, achieved a 17.1% compound annual growth rate.

• Speaker #1

  17.1% CAGR, not bad.

• Speaker #0

  And here's the key part for you. It did that with a volatility of just 9.2%. Wow,

• Speaker #1

  so high returns with relatively low volatility. That sounds almost too good to be true. But wait, I remember there was also an out-of-sample period, right? That's the real test.

• Speaker #0

  You're absolutely right.

• Speaker #1

  Because it's using data the strategy hasn't seen before. So how did it perform on that unseen data?

• Speaker #0

  And that's where we see how robust this strategy really is.

• Speaker #1

  Okay, lay it on me. What kind of returns are we talking about out of sample?

• Speaker #0

  In the out-of-sample period, PAA2 still delivered a 10.5% CAGR.

• Speaker #1

  10.5%. So a bit lower than the in-sample, but still pretty solid.

• Speaker #0

  Though the volatility was a bit higher at 8.8%.

• Speaker #1

  Okay, so a little bump in volatility. Understandable. Still, there's just some... Pretty impressive numbers, especially considering that this was during a period with lower risk-free rates. You know, I'm curious, how did this strategy actually compare to just holding a basic 60-40 portfolio? Because that's what a lot of people think of as a balanced, relatively low-risk approach.

• Speaker #0

  That's a great question, and it's one the paper addresses directly.

• Speaker #1

  Okay, good, good. So how did it stack up against the classic 60-40?

• Speaker #0

  In both the in-sample and out-of-sample periods. PA2 significantly outperformed the traditional 60-40 benchmark, particularly in terms of risk-adjusted returns.

• Speaker #1

  So it wasn't just about beating the market, but also about doing it in a safer, more controlled way. Interesting.

• Speaker #0

  It consistently achieved higher returns with lower volatility and smaller drawdowns.

• Speaker #1

  Yeah, that's the dream, right? Higher returns with less risk. So they're really onto something here. You know, this is all starting to make sense, but I'm still a bit fuzzy on the specifics of those different PAA variations, PAA0, PAA1, and PAA2. What exactly makes them different besides that protection level you mentioned?

• Speaker #0

  Let's break that down in more detail.

• Speaker #1

  Yeah, let's get into the nitty gritty.

• Speaker #0

  Because understanding those nuances can help you see which version might be best suited for your own risk tolerance and investment goals.

• Speaker #1

  Right, right. Let's dive into those variations a bit more. So as you know, all three PAA versions, they follow the same basic trading rules.

• Speaker #0

  Yeah, those SMAs we talked about.

• Speaker #1

  Using SMAs to ride those upward trends.

• Speaker #0

  Right. And that market breadth indicator to adjust the allocation.

• Speaker #1

  To adjust the safe asset allocation. Exactly. OK. But the key difference lies in how aggressively they respond to that market breadth indicator. Oh,

• Speaker #0

  OK. So it's like they all have the same playbook, but they have different interpretations of when to call an audible.

• Speaker #1

  Exactly. PAA0, the least protective version.

• Speaker #0

  PAA0, the least protective.

• Speaker #1

  It takes a more relaxed approach. It simply allocates to bonds in proportion to the number of, how do we want to call them, bad assets?

• Speaker #0

  The bad assets, meaning?

• Speaker #1

  Meaning assets that are showing negative momentum. Oh,

• Speaker #0

  okay. Got it. So if like half the assets in their universe are looking bearish.

• Speaker #1

  Right. Half are looking bearish.

• Speaker #0

  PAA zero would put 50% of the portfolio in the bonds.

• Speaker #1

  That's right. It's like a basic risk management system. Okay. But then we have PAA1, which is a bit more Ausha.

• Speaker #0

  PAA1, yeah.

• Speaker #1

  It starts increasing the bond allocation more aggressively as that market breadth indicator starts flashing warning signs.

• Speaker #0

  So for the same 50% of bearish assets, PAA1 might put 60% or even 70% into bonds.

• Speaker #1

  Yeah, it's playing it safer.

• Speaker #0

  Playing it safer.

• Speaker #1

  Great. Precisely. And then we have PAA2, the most protective variant.

• Speaker #0

  The one that slams on the brakes.

• Speaker #1

  Which really slams on the brakes when things start looking dicey. Dicey, yeah. It might allocate... 80% or even 90% to bonds in that same scenario.

• Speaker #0

  Wow. So it's really battening down the hatches when it senses a storm brewing.

• Speaker #1

  Exactly.

• Speaker #0

  But hold on. If PA2 is so risk averse, wouldn't that mean it misses out on potential gains? When the market is doing well?

• Speaker #1

  That's a great question. And it's something the researchers explored in their back tests. Okay. Interestingly, even though PAA2 is the most Ausha, it doesn't lag too far behind the other versions in terms of returns, especially in the long run.

• Speaker #0

  Okay, so it's not sacrificing too much on the upside.

• Speaker #1

  And remember, it achieved those returns with significantly lower volatility and drawdowns.

• Speaker #0

  So it's not just about how high your returns are, but also about how smooth the ride is. It's like the difference between a roller coaster and a scenic train journey.

• Speaker #1

  I like that analogy.

• Speaker #0

  You might reach the same destination. Yeah. But the experience is totally different.

• Speaker #1

  Exactly.

• Speaker #0

  Now, remember we talked about how they used different bond ETFs as the safe asset.

• Speaker #1

  Oh, yeah, the safe asset.

• Speaker #0

  They explored using IEF.

• Speaker #1

  IEF, uh-huh.

• Speaker #0

  Which tracks longer-term treasury bonds. Longer-term. And SHY, which tracks shorter-term one.

• Speaker #1

  Shorter-term. Got it.

• Speaker #0

  Yeah. That was interesting. It was. What was the verdict on that? Is one clearly better than the other?

• Speaker #1

  Well, it's not so much about a clear winner, but rather understanding the tradeoff.

• Speaker #0

  The tradeoffs, okay.

• Speaker #1

  SHY, with its shorter maturity, might be more resilient if interest rates start rising rapidly.

• Speaker #0

  Because it's not locked in for as long.

• Speaker #1

  Right. But IEF, with its longer maturity, could potentially offer higher returns in a stable or falling interest rate environment.

• Speaker #0

  Ah, so it's like choosing between a nimble speedboat and a sturdy cargo ship.

• Speaker #1

  I love these analogies. You're on a roll.

• Speaker #0

  Depends on what kind of waters you're navigating.

• Speaker #1

  Exactly.

• Speaker #0

  So which one do they recommend in the paper?

• Speaker #1

  They actually even tested a dynamic approach.

• Speaker #0

  A dynamic approach.

• Speaker #1

  That switched between SHY and IEF based on their momentum. But that's maybe getting a bit too complex for most investors.

• Speaker #0

  Yeah, probably.

• Speaker #1

  The key takeaway is that you have options. And you can choose the safe asset that aligns best with your own outlook on interest rates and your overall risk tolerance.

• Speaker #0

  So we've got these different PAA versions, each with its own level of protection.

• Speaker #1

  Right. PAA 0, 1, and 2.

• Speaker #0

  And we've got some choices to make about which safe asset to use.

• Speaker #1

  Exactly.

• Speaker #0

  But ultimately, what's the big takeaway here? What should we be walking away with from this deep dive?

• Speaker #1

  The core message of PAA is that it's all about achieving absolute returns.

• Speaker #0

  Absolute returns, meaning?

• Speaker #1

  Meaning consistent, positive returns. Okay. While prioritizing risk management.

• Speaker #0

  So it's not about... you know, trying to time the market perfectly. Right. Or chase the highest possible returns, but rather about protecting your capital and achieving steady growth over time.

• Speaker #1

  Exactly. It's like having a financial seatbelt for your portfolio.

• Speaker #0

  Oh, I like that. A financial seatbelt.

• Speaker #1

  It's there to protect you during those sudden market crashes.

• Speaker #0

  Yeah, those crashes that can really derail your long-term goals.

• Speaker #1

  Exactly.

• Speaker #0

  And what's really interesting is that the PAA strategy, even with its focus on risk management, still managed to outperform the PAA strategy. perform the traditional 60-40 benchmark in their back tests.

• Speaker #1

  Yeah, that's pretty impressive. It sounds like they've managed to square the circle.

• Speaker #0

  Achieving both growth and safety. Right. But, you know, this is all based on historical data.

• Speaker #1

  Of course, historical data,

• Speaker #0

  right? What about the real world?

• Speaker #1

  Yeah, the real world is a bit messier.

• Speaker #0

  What are some things someone would need to consider if they were actually thinking about using PAA to manage their own money?

• Speaker #1

  That's where things get really interesting. Because, as you know, Back tests are a great starting point.

• Speaker #0

  Yeah, they are.

• Speaker #1

  But they're not always a perfect reflection of what might happen in the future.

• Speaker #0

  Yeah, the markets are always throwing curveballs.

• Speaker #1

  Yeah.

• Speaker #0

  So what are some of the practical considerations someone would need to think about before they jump in and start trading this?

• Speaker #1

  Let's delve into that next.

• Speaker #0

  Yeah, let's get practical.

• Speaker #1

  Because that's what really matters if you're trying to apply this to your own portfolio. So if you're thinking about actually implementing this PAA strategy. Yeah,

• Speaker #0

  taking it from theory to practice.

• Speaker #1

  There are a few things to consider.

• Speaker #0

  Practical hurdles. Yeah. Real world stuff.

• Speaker #1

  Yeah. One of the first things that comes to mind. Hit me. Is trading costs.

• Speaker #0

  Oh yeah. The fees.

• Speaker #1

  PAA involves buying and selling assets as their momentum shifts.

• Speaker #0

  Right. Got to stay with the trend.

• Speaker #1

  So those transaction fees, they can eat into your returns if you're not careful.

• Speaker #0

  That's a good point. Nobody wants to give back their games to the brokerage.

• Speaker #1

  Right. Exactly.

• Speaker #0

  But haven't trading costs come down a lot in recent years?

• Speaker #1

  They have.

• Speaker #0

  Yeah. I mean, there are all these discount brokerages and platforms offering commission free trading now.

• Speaker #1

  You're absolutely right.

• Speaker #0

  Yeah. Makes things a lot easier.

• Speaker #1

  It's much easier now to find a cost effective way to trade. Right. But it's still something you need to factor in. Makes sense. Especially if you're planning to trade frequently.

• Speaker #0

  Oh, right. The more you trade, the more those little fees can add up. Exactly. Even if they're small.

• Speaker #1

  You also have to consider. the expense ratios of the ETFs themselves. Well,

• Speaker #0

  the ETFs themselves have fees too.

• Speaker #1

  Even though they're generally lower than mutual funds.

• Speaker #0

  Okay, lower than mutual funds, good.

• Speaker #1

  Those fees can still add up over time.

• Speaker #0

  Right. Those little percentages can really make a difference in the long run.

• Speaker #1

  Exactly.

• Speaker #0

  So you're saying it's important to like shop around.

• Speaker #1

  It is, yeah.

• Speaker #0

  Find ETFs that are... Both cost effective.

• Speaker #1

  Right. Cost effective.

• Speaker #0

  And closely track the index they're supposed to represent.

• Speaker #1

  Exactly.

• Speaker #0

  Okay. So fees are definitely a factor. They are. Now, another practical consideration is the choice of ETFs.

• Speaker #1

  Right. The specific ETFs you use.

• Speaker #0

  Remember, the paper used a specific set of 12 ETFs. But you might have different investment goals or preferences.

• Speaker #1

  Of course. Different investors, different goals.

• Speaker #0

  You might want to expand that universe.

• Speaker #1

  Yeah. Go beyond those 12.

• Speaker #0

  Maybe include some more niche sectors or even explore alternative asset classes.

• Speaker #1

  That makes sense. Customizing it to your needs.

• Speaker #0

  It's like having a recipe.

• Speaker #1

  Uh-huh.

• Speaker #0

  But you can adjust the ingredients to suit your own taste.

• Speaker #1

  Exactly.

• Speaker #0

  But wouldn't that also add complexity?

• Speaker #1

  It could,

• Speaker #0

  yeah. I mean, the more assets you have, the harder it is to keep track of everything.

• Speaker #1

  Right. More moving parts.

• Speaker #0

  And make sure you're following the trading rules correctly.

• Speaker #1

  That's a valid concern. Definitely something to consider.

• Speaker #0

  You have to weigh the benefits of diversification against the added complexity.

• Speaker #1

  This is the trade-off, yeah.

• Speaker #0

  And this is where technology can be really helpful.

• Speaker #1

  Oh, absolutely. Technology can be a lifesaver here.

• Speaker #0

  You could use a trading platform or software that allows you to automate some of the processes.

• Speaker #1

  Great. Take some of the manual work out of it.

• Speaker #0

  Like calculating those SMAs and even executing the trades based on your predetermined rule.

• Speaker #1

  Ah,

• Speaker #0

  so it's like having a co-pilot in the cockpit.

• Speaker #1

  I like that analogy.

• Speaker #0

  Helping you manage all the technical stuff.

• Speaker #1

  Right. Taking care of the details.

• Speaker #0

  So you can focus on the big picture.

• Speaker #1

  Exactly. Yeah.

• Speaker #0

  And speaking of the big picture, we also have to talk about the psychological aspect of using a strategy like PAA.

• Speaker #1

  The psychological side of it. Yeah, that's often overlooked.

• Speaker #0

  It's designed for those who prioritize capital preservation.

• Speaker #1

  Capital preservation, right.

• Speaker #0

  And consistent, though potentially moderate, returns.

• Speaker #1

  Steady and safe. That's the focus.

• Speaker #0

  So it's not for the adrenaline junkies. Right.

• Speaker #1

  Not for the thrill seekers.

• Speaker #0

  Who get their thrills from chasing the next hot stock. Uh huh. Or trying to time the market perfectly.

• Speaker #1

  Yeah, this is more of a long game.

• Speaker #0

  PAA requires patience and discipline.

• Speaker #1

  Patience, discipline. Those are key.

• Speaker #0

  It's about sticking to the plan even when the market gets volatile.

• Speaker #1

  Right. Riding out the storms.

• Speaker #0

  Knowing that those safety mechanisms are there to protect you in the long run.

• Speaker #1

  Exactly. That's the whole point of the protective part.

• Speaker #0

  It's like being a marathon runner rather than a sprinter.

• Speaker #1

  Another great analogy.

• Speaker #0

  It's about pacing yourself and staying focused on the finish line.

• Speaker #1

  Exactly. The long-term goal.

• Speaker #0

  You know, as we wrap up this deep dive into PAA.

• Speaker #1

  Yeah, it's been a fascinating discussion.

• Speaker #0

  I'm struck by how much thought and research went into developing this strategy.

• Speaker #1

  I agree. It's a very well thought out approach.

• Speaker #0

  It's clearly not just some random idea someone pulled out of a hat.

• Speaker #1

  Definitely not. A lot of careful analysis went into this.

• Speaker #0

  It's a testament to the power of quantitative approaches to investing.

• Speaker #1

  Quantitative approaches, data-driven decision-making.

• Speaker #0

  By systematically analyzing data and back-testing different scenarios.

• Speaker #1

  Right, taking the emotion out of it.

• Speaker #0

  They've managed to create a strategy that aims to balance risk and reward.

• Speaker #1

  Finding that sweet spot between risk and reward.

• Speaker #0

  In a way that could potentially benefit a wide range of investors.

• Speaker #1

  Exactly. It's a very versatile strategy.

• Speaker #0

  It's like they've taken the guesswork out of investing. Uh-huh. And replaced it with a data-driven approach.

• Speaker #1

  A data-driven approach. Yeah, that's the future of investing.

• Speaker #0

  And while no strategy is perfect.

• Speaker #1

  Of course, no guarantees in the market.

• Speaker #0

  Or guaranteed to work in every market condition.

• Speaker #1

  Right. Always got to be prepared for the unexpected.

• Speaker #0

  PAA certainly presents a compelling alternative to traditional term deposit.

• Speaker #1

  A compelling alternative, yeah.

• Speaker #0

  Especially for those who are seeking high- higher potential returns without taking on excessive risk.

• Speaker #1

  Right. That's the key, managing that risk.

• Speaker #0

  I think that's a great way to sum it up.

• Speaker #1

  I agree.

• Speaker #0

  PAA offers a structured and systematic approach to managing your investments.

• Speaker #1

  Structure and system. That's what we like.

• Speaker #0

  With a focus on capital preservation and consistent returns.

• Speaker #1

  The foundations of good investing.

• Speaker #0

  And as always, we encourage you to do your own research.

• Speaker #1

  Always do your own research. Yeah.

• Speaker #0

  Explore the original paper. And consider if BAA might be a good fit for your own portfolio and investment goals.

• Speaker #1

  Right. See if it aligns with your own personal circumstances.

• Speaker #0

  Thank you for tuning in to Papers with Backtest podcast.

• Speaker #1

  It's been a pleasure, as always.

• Speaker #0

  We hope today's episode gave you useful insights.

• Speaker #1

  Hopefully some food for thought.

• Speaker #0

  Join us next time as we break down more research.

• Speaker #1

  More research, more insights coming your way.

• Speaker #0

  And for more papers and backtests, find us at htpps.paperswithbacktest.com.

• Speaker #1

  That's Papers with Backtest.com.

• Speaker #0

  Happy trading!