Simulations of market risk aversion indicators | Looking for Alpha
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New three-state risk indicator
In addition to the “risk-on” and “risk-off” states, we are introducing a “risk-uncertain” state for periods of high uncertainty about the direction of the market. During the risk transition, we invest in a combination of risky and risk-uncertain. “safe” assets In my simulations, I used 50% equities and 50% treasury funds.
We have two variants of the risk indicator that work pretty much the same way. A variant uses the four pairs of ETFs (DBB-UUP), (XLY-XLP), (XLI-XLU), (SLV-GLD). It is risky when 3 pairs have total returns below certain thresholds. The second variant uses only the first three pairs and is at risk when 2 pairs have total returns below the thresholds.
The three states are defined as follows:
- Risk-on when the 3 pair and 4 pair risk indicators are activated.
- Risk disabled when the 3 pair and 4 pair risk indicators are disabled.
- Uncertain risk when 3 pairs are off but 4 pairs are on.
Simulations from January 2008 showed the following number of trading days in risky states:
- Risk over 2076 days (58%)
- Abandonment of risk 1079 days (30%)
- Uncertain risk 411 days (12%)
Simulation results
Simulations were performed with three portfolios from January 2008 until today, 01/28/2022. The summary results are presented in the following tables.
Table 1. Portfolio without leverage. Current assets: PPH, SMH, SPYV, XLF
|
2007-22 NONLEV |
CAGR |
stdev |
maxDD |
Sharpe R. |
Sortino R |
|
2 states 3 pairs |
21.56% |
17.66% |
-17.39% |
1.22 |
1.62 |
|
2 states 4 pairs |
24.35% |
18.57% |
-19.97% |
1.31 |
1.75 |
|
3 states |
23.00% |
17.41% |
-17.39% |
1.32 |
1.73 |
Table 2. Leveraged portfolio. Current assets: SPXL, NAIL, SOXL, FAS
|
2007-22 UP |
CAGR |
stdev |
maxDD |
Sharpe R. |
Sortino R |
|
2 states 3 pairs |
48.75% |
41.93% |
-43.89% |
1.16 |
1.39 |
|
2 states 4 pairs |
55.49% |
48.91% |
-66.10% |
1.13 |
1.38 |
|
3 states |
52.40% |
42.30% |
-44.27% |
1.24 |
1.48 |
Table 3 Large Cap Stock Portfolio: Common Assets: COKE, APA, DVN, KSS, F, DLTR, HAL, QCOM
|
2007-22 LARGE CAPS |
CAGR |
stdev |
maxDD |
Sharpe R. |
Sortino R |
|
2 states 3 pairs |
39.28% |
25.84% |
-27.11% |
1.52 |
2.02 |
|
2 states 4 pairs |
43.03% |
27.55% |
-28.75% |
1.56 |
2.11 |
|
3 states |
42.44% |
25.37% |
-27.11% |
1.64 |
2.17 |
Author
Figure 1. Equity curves of 3-state portfolios
Author
Figure 2 Equity curves of the leveraged portfolio for the three strategies.
Source: Author
Table 4. Annual unleveraged portfolio returns for the three strategies
|
4-Pairs |
3 pairs |
3 states |
|
|
2008 |
27.25% |
24.93% |
26.24% |
|
2009 |
43.21% |
21.80% |
25.56% |
|
2010 |
42.17% |
33.17% |
40.30% |
|
2011 |
20.35% |
38.70% |
36.77% |
|
2012 |
9.71% |
18.73% |
14.31% |
|
2013 |
17.00% |
17.00% |
17.00% |
|
2014 |
20.02% |
17.18% |
15.78% |
|
2015 |
6.76% |
-0.37% |
0.08% |
|
2016 |
23.35% |
17.30% |
21.48% |
|
2017 |
16.87% |
14.71% |
16.87% |
|
2018 |
5.35% |
-3.37% |
4.16% |
|
2019 |
25.51% |
19.04% |
21.53% |
|
2020 |
100.56% |
84.56% |
89.74% |
|
2021 |
28.54% |
28.54% |
28.54% |
|
2022 |
-10.29% |
-2.56% |
-6.44% |
Discussion
The results are consistent for the three portfolios. Here are the main findings.
- The 3-state variant achieves the highest risk-adjusted returns, as indicated by the Sharpe ratio.
- The 2-state, 4-pair variant has the highest returns, but also the largest drawdowns.
- The 3-state and 2-state 3 pair risk indicators have similar volatility (stdev) and roughly the same declines.
conclusion
The 4-pair variant achieves the highest return in almost all years except 2011 and 2012. If the primary objective is to maximize returns, then the 2-state 4-pair is the preferred choice.
On the other hand, if the goal is to maximize risk-adjusted returns, then state 3 is the best choice.