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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.
Fundamental reason
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.
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Market Factors
Confidence in Anomaly's Validity
Period of Rebalancing
Number of Traded Instruments
Complexity Evaluation
Financial instruments
Backtest period from source paper
Indicative Performance
Notes to Indicative Performance
Estimated Volatility
Notes to Estimated Volatility
Maximum Drawdown
Notes to Maximum drawdown
Sharpe Ratio
Regions
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 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.
Hedge for stocks during bear markets
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.
Out-of-sample strategy's implementation/validation in QuantConnect's framework(chart, statistics & code)
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Source paper
Maewal, Bock: Paired-Switching for Tactical Portfolio Allocation
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.
Other papers
Schizas, Thomakos: Market timing using asset rotation on exchange traded funds: a meta-analysis on trading performance
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
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.
Zakamulin: Trend Following with Momentum Versus Moving Average: A Tale of Differences
Abstract: Despite the ever-growing interest in trend following and a series of publications in academic journals, there is still a great shortage of theoretical results on the properties of trend following rules. Our paper fills this gap by comparing and contrasting the two most popular trend following rules, the Momentum (MOM) and Moving Average (MA) rules, from a theoretical perspective. Our approach is based on the return-based formulation of trading rules and modelling the price trends by an autoregressive return process. We provide theoretical results on the similarity between various trend following rules and the forecast accuracy of trading rules. Our results show that the similarity between the MOM and MA rules is rather high and increases with increasing trend strength. However, as compared to the MOM rule, the MA rules have a more robust forecast accuracy of the future direction of price trends. As a result, under uncertain market dynamics the MA rules tend to gain an advantage over the MOM rule. Overall, the results reported in this paper help traders to understand more deeply the properties of trend following rules as well as the differences and similarities between them.