TECHNICAL ASSET MANAGEMENT
OPTIMAL DESIGN OF VOLATILITY-DRIVEN
ALGO-ALPHA TRADING STRATEGIES
Guido Giese derives a model for the performance and risk analysis of algorithmic
investment strategies that invest in a mixed portfolio of the equity and money
markets. It is based on a frequent rebalancing algorithm that responds to changes
in volatility of the underlying equity market using a pre-defined response function.
A
logorithmic investment schemes that invest
in a frequently rebalanced portfolio of equity
and fixed-income have become more common
in recent years. Some are even available to
retail investors, through index-tracking
products. One can distinguish between two basic types of
existing investment schemes: pure return strategies, such as
leveraged index-based exchange-traded funds (ETFs) that
borrow in the money market to offer leveraged equity
returns for risk-seeking investors; and risk-controlled
strategies for risk-averse investors, which shift part of the
equity investment into the money market during periods of
high volatility to protect the investor from serious losses.
In this article, we analyse strictly rules-based investment
schemes that combine positions in equities and money
markets, where we typically assume an equity investment in
the form of a liquid index to ensure the investment scheme
can be replicated and traded in a cost-efficient way. Further,
we allow the equity and money-market positions to be either
long or short to allow leveraged, de-leveraged and short
trading strategies.
We focus on investment schemes that use equity market
volatility as a key input factor in determining the size of the
equity investment and to trigger a rebalancing between it
and the money-market investment. The reasons for using
volatility as a key allocation factor are twofold:
There is a strong negative correlation between the
performance of equities and equity volatility, that is, falling
equity markets typically coincide with rising levels of
volatility and vice versa. This has led to many volatility-driv-
en products in the market.
It has been shown (see Despande, Mallick & Bhatia, 2009,
Cheng & Madhavan 2009, and Giese, 2010) that frequently
rebalancing investment schemes between equity and
fixed-income suffers from rebalancing losses that are
proportional to the variance of the underlying equity index,
as we will also show later in this article. Therefore, using the
volatility of the underlying equity market as an input factor
for the asset allocation is essential to minimise the adverse
effects of rebalancing.
Rules-based mixed equity and fixed-income investment
schemes have been analysed in the literature before in
several different contexts. The first and influential contribu-
tion of Merton (1971) was based on an investor who
maximises a pre-defined utility function on a fixed time
horizon, which resembles the decision problem of an
34 ETF Risk: July 2012 risk.net/etf-risk
investor saving for his retirement.
Further, the basic idea to shift investment between the
risk equity market and a safe fixed-income investment has
led to the development of portfolio insurance investment
models (see Perold & Sharpe, 1995) that rebalance the
portfolio to ensure a certain minimum capital protection
level.
In this article, we analyse rules-based rebalancing
investment schemes from a pure expected return and
expected Sharpe ratio perspective, without referring to an
arbitrary utility function or time horizon or capital
protection level. We are interested in creating investment
schemes that can easily be tracked and issued in the form of
retail investment products such as ETFs or certificates where
optimising the performance or the risk-return profile is the
dominating investment target.
The structure of this article is as follows: first, we derive
a general model description for investment strategies that
frequently rebalance between an equity and money-market
investment, using equity volatility as an input parameter.
The key results are expressions for the expected return and
expected Sharpe ratio of the investment scheme. Then, we
analyse existing strategies (that is, leveraged and risk-con-
trol strategies) before we derive the optimal rebalancing
strategies for return-maximising and risk-return maximis-
ing investment schemes. We will give a mathematical proof
that these optimal strategies have a higher expected return
or higher expected Sharpe ratio than the underlying equity
investment, irrespective of the chosen equity index. We
therefore argue that these strategies are algorithmic alpha
strategies. Finally, we add empirical evidence to the
mathematical proofs of superior returns and superior
Sharpe ratios for bespoke optimised strategies.
Model description
We assume a liquid underlying equity index St to model the
equity investment of our investment scheme that follows a
stochastic process with growth rate u and stochastic volatility
st:
dSt = St (udt + σ t dWt ) (1)
where Wt denotes a standard Wiener process with constant
drift u. As a general investment concept, we consider an
investment strategy It that uses volatility as an asset
allocation signal in the sense that it invests a proportion of
R(stm) into the underlying equity index St and 1 – R(stm)