Paired Switching

Paired switching strategy is a subset of asset rotational 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 negative correlation by switching between two assets than by traditional asset mixing. As both assets are negatively correlated, there is high probability that portfolio performance is lower in case of 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.

Fundamental reason

There is high probability that portfolio performance is lower in case of mix than return for individual assets if two assets are negatively correlated. The strategy's performance then depends on accuracy of the timing rule.

Markets traded
equities, bonds
Confidence in anomaly's validity
Moderately strong
Notes to Confidence in anomaly's validity
Academic paper contains look-ahead bias as it uses all known historical data to pick funds/ETFs/assets with negative correlation. More appropriate way would be to use rolling (expanding) historical window to pick assets.
Period of rebalancing
Quarterly
Notes to Period of rebalancing
Number of traded instruments
2
Notes to Number of traded instruments
Complexity evaluation
Simple strategy
Notes to Complexity evaluation
Financial instruments
stocks, ETFs, funds
Backtest period from source paper
1991-2011
Indicative performance
11.30%
Notes to Indicative performance
per annum, data form table 1, backtest using Vanguard VFINX & VUSTX funds
Estimated volatility
9.30%
Notes to Estimated volatility
data from table 1
Maximum drawdown
not stated
Notes to Maximum drawdown
Sharpe Ratio
0.78

Keywords:

momentum, asset class picking, rotational system, market timing, fund picking

Simple trading strategy

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 the 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.

Hedge for stocks during bear markets

Partially - 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". Selected strategy contains equities and TAA strategy tries to rotate out of them during time of stress. Therefore proposed strategy isn't mainly used as an addon to portfolio to hedge equity risk directly, but it is more an overlay which can be used to manage percentual representation of equities (or "equity like asssets") in a portfolio. Tactical asset allocation framework can decrease overall risk of equities in a portfolio and it can improve the risk-adjusted returns.

Source Paper

Maewal, Bock: Paired-Switching for Tactical Portfolio Allocation
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1917044
Abstract:
Paired-switching refers to investing in one of a pair of negatively correlated equities/ETFs/Funds and periodic switching of the position on the basis of either the relative performance of the two equities/ETFs/Funds over a period immediately prior to the switching or some other criterion. It is based upon the idea that if the returns of two equities are negatively correlated, the overlapping of the periods during which the equities individually yield returns greater than their mean values will be infrequent. Consequently, if the criterion for switching is even minimally accurate in its ability to identify the boundaries of such periods, there is a possibility of improving the performance of the portfolio consisting of the two equities over the portfolio wherein the two equities are statically weighted on the basis of traditional methods such as, for example, variance minimization. In this paper we present some results that indicate that some very simple criteria for paired-switching can lead to lower volatility without any significant penalty in terms of lower returns.

Hypothetical future performance

Strategy's implementation in QuantConnect's framework (chart+statistics+code)

Other Papers

Schizas, Thomakos: Market timing using asset rotation on exchange traded funds: a meta-analysis on trading performance
http://businessperspectives.org/journals_free/imfi/2013/imfi_en_2013_02cont_Schizas.pdf
Abstract:
The ultimate goal of any “paper” investment strategy is to achieve real-life profitability. This paper measures the performance of a trading rule based on the relative pricing and relative volatility of a rotation strategy between two assets, using data from passive ETFs. To avoid problems of pair selection we work with meta-data obtained after the evaluation of a large number of 351 pairs of ETFs. In this way the authors analyze the performance of the proposed strategy on the cross-section of different ETFs. The results show that rotation trading, as applied in this paper, offers advantages even when the simplest model is used in generating trading signals. Furthermore, the authors find that the differences in the actual mean returns (over the evaluation period), the correlation of the pair components and to (a lesser extend) the volatilities of the ETFs can explain the success of the rotation strategies.

Clare, Seaton, Smith, Thomas: Absolute Momentum, Sustainable Withdrawal Rates and Glidepath Investing in US Retirement Portfolios from 1925
https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3347183
Abstract:
A significant part of the development in pension provision in many countries is the emergence of ‘Target Date Funds’ or TDFs. In this paper we examine the proposition of de-risking through life and the guidance offered by TDFs in the decumulation phase following retirement. We investigate the withdrawal experience associated with Glidepath Investing in the US since 1925 for conventional bond-equity portfolios. We find one very powerful conclusion: that smoothing the returns on individual assets by simple absolute momentum or trend following techniques is a potent tool to enhance withdrawal rates, often by as much as 50% per annum! And, perhaps of even greater social relevance is that it removes the ‘left-tail’ of unfortunate withdrawal rate experiences, i.e. the bad luck of a poor sequence of returns early in decumulation. We show that diversifying assets over time by switching between an asset and cash in a systematic way is potentially more important for the retirement income experience than diversifying one’s portfolio across asset classes. We also show that Glidepath investing is only sensible within a few years of the target date. This finding provides succour to enthusiasts for target date investing in the face of the growing hostility in the literature.