For a brief refresher, I took Mebane Faber's Tactical Asset Allocation strategy and looked at adding risk-parity portfolio weights and then also at looking at within sector momentum strategies. So the basic strategy outlined by Faber (2007) is to go asset classes that are above their 10 month moving average and remain in cash the rest. Classes are equally weighted (and he uses US stocks, foreign stocks, commodities, real estate, and 10 year US bonds).
My addition is to weigh different asset classes so that each contributes equally to the risk. The idea is that bonds are much less risky than stock, so that the contribution to overall portfolio risk is dominated by stocks. If you leverage up the portfolio, then you're basically long US stocks and the other positions don't really matter so much in determining your returns.
The second part is to look within the asset class instead of as a whole. Given the research by Jegadeesh and Titman, my decision for choosing what sectors to invest was determined by momentum. For the purposes of this study, I have been concentrating on the past four months worth of momentum and holding at least for two months. The top 25% of individual securities are used. As an example, instead of going long only Commodities, I might be only long oil and gold.
So the information I am going to present are first the 2008 returns of each strategy (and leveraged 100%), followed by tables with the historical returns, and their historical charts (scaled by natural logs). I'll follow up at the end with a summary of the performance of the CTAA and what it was holding at the end of the year.
The following are the historical charts, investing $1 in each strategy (and scaled by the natural log).
So, at the end of 2008, you would want to be in bonds (though you would be losing money in them now, suggesting TAA is off to a bad start), and that's about it. Risk Parity Weights are approximately at 37% bonds, 18% Commodities, and close to 15% in the rest of the asset classes. The Component TAA is invested in SHY, IEF, AGG, TLT, and MBB equally weighted in bonds (avoiding corporate, international, municipal, and TIPS ETFs).
Obviously, I don't think the Component TAA is something that should be blindly followed, the way that most people could blindly follow the TAA. It is designed to perform best when momentum is a factor (like during booms) and is expected to underperform at times when the TAA adds most value (by being in cash). It was particularly hurt in 2008 due to the collapsing energy prices. Risk-parity weights as a tool to reduce risk, however, worked well in 2008.
