Long Backtests and Madoff’esque Returns
One last thought on this month’s series re: Tactical Asset Allocation (TAA).
Consider this backtest of our TAA model (red) vs the S&P 500 (grey) from 1971.
I fear that when investors look at a backtest like this one that covers such a long span of time their first thought is “wow, look at those smooth Madoff’esque returns, I’ll never have another sleepless night again”.
That would be the wrong conclusion.
The problem is that all the wins and losses that can make a strategy so gut-wrenching to trade in the real-world get lost when viewed from 30,000 feet up. Heck, even the S&P 500 looks like a pussy cat from up here (the 1987 crash is barely even noticeable).
2008 would have been a great year for the model (TAA in red, S&P 500 in grey)…
…but 2009 would have been uber painful…
…and neither is obvious just looking at the equity curve.
I show equity curves on this blog because it’s what most readers expect to see, but in my own work I instead using “rolling volatility-adjusted returns” (read more).
Consider the graph below…
Each point on the graph is the Sharpe Ratio of the model over the previous year. The Sharpe Ratio is a measure of return relative to volatility. High numbers are good and low numbers bad.
This graph makes it clear that the model has, despite that smooth equity curve, frequently gone through periods of weak performance.
I also look at rolling excess volatility-adjusted returns, or volatility-adjusted returns relative to some benchmark. The graph below shows the same rolling Sharpe Ratio minus the Sharpe Ratio for the S&P 500.
Here we see that the model has frequently underperformed a simple buy & hold investment (in some years by a ginormous margin).
. . . . .
When assessing a strategy, the 30,000 foot view definitely matters, and from a 30,000 foot view the TAA model has clearly trounced the market.
But the point of this post is to show that even the best strategy goes through long rough patches that might not be apparent from 30,000 feet.
The “rolling volatility-adjusted return” approach I’ve shown here is one tool to help the investor get a more realistic view of how consistently a strategy performed and how it might have actually felt to trade the strategy in the real world.
. . . . .
Filed under: Tactical Asset Allocation | 15 Comments