01 Apr Learning From Mebane Faber's "A Quantitative Approach to Tactical Asset Allocation"

Quantitative market timing utilising a 10-month moving average approach reduces portfolio risk significantly.

In this article, Absolute Momentum will be used interchangeably with trend following or time series momentum. Relative Momentum will be used interchangeably with cross-sectional momentum or relative strength.

The paper explores a quantitative market timing approach that manages risk of the portfolio on top of traditional risk reduction from diversification. The approach signals when an investor should exit a risky asset in favour of risk free investments. It utilises a 10-month simple moving average to achieve a long term trend following approach across multiple global traditional asset classes.

The trend following approach is compared to a “Buy and Hold” portfolio, with the same 5 asset classes equally weighted.

The trend following portfolio also uses equal weighting and treats each asset class independently, either long the asset class or in cash with its 20% allocation of the funds.

“Figure 13b” of the paper (reproduced below) shows that the trend following portfolio marked as GTAA (Global Tactical Asset Allocation) delivered better performance compared to the “Buy and Hold” portfolio. It also reduces maximum drawdown significantly.

Source: A Quantitative Approach to Tactical Asset Allocation

The portfolio is tested on various other moving averages lengths and the results are similar, suggesting stability of the parameter and robustness of the strategy. This is detailed in “Figure 15” of the paper (reproduced below).

Source: A Quantitative Approach to Tactical Asset Allocation

The paper was first published in 2005 and hence performance from 2006 onwards can be considered out of sample. Performance from 2006 and 2012 was as expected with higher risk-adjusted returns and significantly reduced maximum drawdown.

The paper extends the study from 5 to 13 traditional asset classes and selects the top six out of the thirteen assets as ranked by an average of 1, 3, 6, and 12-month total returns (momentum). The assets are only included if they are above their long-term moving average, otherwise that portion of the portfolio is moved to cash. Performance is consistent over the last 30 years with Sharpe Ratio at 1.06.

Research Paper: A Quantitative Approach to Tactical Asset Allocation

Author: Mebane T. Faber

Company: Cambria Investment Management