The New Enhanced Bond Rotation Strategy With Adaptive Bond Allocation

On November 2013 I published an article on the Bond Rotation Strategy (BRS) Now, 15 months later, I am presenting an important update for this strategy. Even though the old strategy has done well (see charts here), I think it is very important to constantly validate and improve any investment strategy. Markets change, ETFs change, even we ourselves grow and learn. I am still improving my knowledge and striving to pass on that knowledge.

In November 2014 I presented the Universal Investment Strategy which was based on a variable allocation of the SPY-TLT ETFs.

This new concept of an ETF rotation with variable allocation is very versatile and can be used on all types of strategies. For the BRS strategy, this new way to calculate allocations results in a considerably improved Sharpe (Return/Risk) ratio of the strategy.

Here is the ETF selection for the BRS

Old ETF selection New ETF selection
CWB - SPDR Barclays Convertible Bond CWB - SPDR Barclays Convertible Bond
JNK - SPDR High-Yield Junk Bond (4-7yr) JNK - SPDR High-Yield Junk Bond (4-7yr)
TLH - iShares 10-Year Treasury (9-11yr) TLT - iShares Long-Term Trsry (15-18yr)
  PCY - PowerShares Emerging Mkts Bond (7-9yr)
AGG - iShares Core Total US Bond (4-5yr) not necessary anymore
BOND - PIMCO Total Return ETF not necessary anymore
SHY - Barclays Low Duration Treasury (2-yr) not necessary anymore. The total allocation can go automatically below 100%

An advantage of the adaptive allocation is that we can work with fewer ETFs. We do not need the total return ETFs (AGG, BOND) anymore. The old BRS used these ETFs to achieve a blended way of investing in treasuries and corporate bond ETFs. This was needed because normal switching strategies don’t take into account cross-correlation between ETFs. I had to add total return ETFs so that the strategy ‘knew’ about the possible Sharpe ratio of a blended ETF.

The new strategy, however, does calculate cross-correlations and it will allocate automatically to the top ETFs, so that the Sharpe ratio is maximized.

Cross-correlation is extremely important. If for example the stock market is doing well, then a normal ranking ETF strategy would probably invest in the two highly correlated corporate bonds: JNK and CWB. However a combination of CWB with a negatively correlated treasury TLT would probably have the better Sharpe ratio because of the inverse correlation of the two ETFs. This would reduce volatility and this would result in a higher Sharpe ratio for this ETF pair. 

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