A paired switching strategy is a subset of rotational asset strategies. The simplest form uses two assets (or stocks), which have a negative correlation. Investors then invest in one pair and periodically switch position based on relative performance (or some other criterion). The strategy is based upon the idea that it is easier to exploit a negative correlation by switching between two assets than by traditional asset mixing. As both assets are negatively correlated, there is a high probability that portfolio performance is lower in the case of a mix than return for individual assets.
Academic research shows that if the criterion for switching is even minimally accurate, there is a probability of improving the performance over the portfolio wherein the two assets are statically weighted. The simplicity of this idea is attractive; therefore, we decided to create an independent entry for the strategy as we think that some elements of it could be used in other more complex constructions.
There is a high probability that portfolio performance is lower in the case of a mix than return for individual assets if two assets are negatively correlated. The strategy’s performance then depends on the accuracy of the timing rule.
per annum, data form table 1, backtest using Vanguard VFINX & VUSTX funds
data from table 1
This strategy is very flexible. Investors could use stocks, funds, or ETFs as an investment vehicle. We show simple trading rules for a sample strategy from the source research paper.
The investor uses two Vanguard funds as his investment vehicles – one equity fund (VFINX) and one government bond fund (VUSTX). These two funds have a negative correlation as they are proxies for two negatively correlated asset classes. The investor looks at the performance of the two funds over the prior quarter and buys the fund that has a higher return during the ranking period. The position is held for one quarter (the investment period). At the end of the investment period, the cycle is repeated.
Partially - The selected strategy is a class of “Tactical asset allocation” strategies like the one proposed by Mebane Faber in his famous paper “A Quantitative Approach to Tactical Asset Allocation”. The selected strategy contains equities, and the TAA strategy tries to rotate out of them during the time of stress. Therefore the proposed strategy isn’t mainly used as an add-on to the portfolio to hedge equity risk directly, but it is more an overlay that can be used to manage the percentual representation of equities (or “equity-like assets”) in a portfolio. The tactical asset allocation framework can decrease the overall risk of equities in a portfolio, and it can improve the risk-adjusted returns.
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