How To Stay Vigilant And Keep Momentum On Your Side

Vigilant Asset Allocation (VAA) is an aggressive tactical asset allocation strategy. It’s designed to help you actively manage your portfolio to take advantage of changing market trends or economic conditions – which could prove extra handy these days. One of the best things about this investing style is that it’s relatively easy to implement using ETFs. But it also doesn’t hurt that it’s got an impressive track record. Let’s dig into how it works…

What are the basic concepts behind the VAA strategy?

VAA is a “momentum strategy”: you invest in asset classes that have recently performed well based on the tendency they have to continue to perform well in the near future. Momentum is a well-studied phenomenon within financial and academic circles. One of the reasons it works is the fact that investors have deep behavioral biases – like herding and extrapolation.

An important concept behind VAA is “dual momentum”, which refers to two types of momentum: relative and absolute. Relative momentum measures how an asset has performed relative to other assets over a certain time period. Absolute momentum, on the other hand, measures whether an asset has actually risen in value over a certain period of time.

You’ll see how VAA incorporates dual momentum in a second. For now, you should know that VAA is an aggressive strategy: each month, it allocates 100% of the portfolio to a single asset from a small basket of either offensive or defensive assets.

Credit where credit is due: the VAA strategy comes from Wouter Keller and JW Keuning's research paper, “Breadth Momentum and Vigilant Asset Allocation”.

Which asset classes does the VAA strategy trade?

VAA trades seven different ETFs, each representing a different asset class or subclass. The ETFs are organized into two different groups, or “universes”: offensive and defensive.

ETFs traded by the VAA strategy. Source: Finimize.

How is the VAA strategy implemented?

The strategy trades and rebalances monthly. So on the last trading day of the month, you would do the following:

Step 1

Calculate a momentum score for each of the seven ETFs. The authors use a “13612W” score – a bit of a mouthful, but here’s how you work it out:

13612W = (12 (p0 / p1 – 1)) + (4 (p0 / p3 – 1)) + (2 * (p0 / p6 – 1)) + (p0 / p12 – 1)

Where p0 = the ETF’s price today, p1 = the ETF’s price one month ago, p3 = the ETF’s price three months ago, and so on.

The first term – (p0 / p1 – 1) – is the ETF’s percentage price change over the past month, and the second term – (p0 / p3 – 1) – is the ETF’s percentage price change over the past three months. You get the idea. Also, notice how the 13612W score overweights the most recent returns: the ETF’s one-month performance is multiplied by 12, its three-month performance is multiplied by a third of that (four), and so on. This gives more recent returns a greater impact on the strategy than older ones.

Step 2

Look at the 13612W scores of the four ETFs in the offensive universe.

• If they’re all positive (absolute momentum), then invest 100% of the portfolio in the ETF with the highest score (relative momentum).
• But if any of the offensive ETFs have a negative score, then invest 100% of the portfolio in the defensive ETF with the highest score – regardless of whether it’s positive or not.

Step 3

Hold onto the ETF until the last trading day of the following month. Then go back and repeat the steps above. Even if the ETF you end up investing in doesn’t change, repeating the steps above ensures that you stick to the strategy.

How has the VAA strategy performed?

Performance tracker AllocateSmartly has compiled robust data on the VAA strategy’s historical performance, even projecting it back to 1970. While looking at this in isolation is all well and good, it’s more informative to compare performance to a benchmark – in this case, a basic 60/40 strategy that invests 60% in US stocks and 40% in US government bonds.

VAA’s performance versus the 60/40’s (logarithmic scale). Source: AllocateSmartly.com.

Measured over the past 50+ years, VAA generated an eye-popping average annual return of 16.6% – significantly higher than the 60/40 benchmark’s 9.4%. But, as you’d expect from an aggressive strategy that’s always fully invested in a single ETF, VAA’s volatility of 12% was higher than the 60/40 portfolio’s 10%. Still, VAA’s strong performance means that the strategy generated much higher investment returns per unit of risk.

What’s more, VAA actually displayed less risk by another important measure: maximum drawdown (MDD) – the largest peak-to-trough decline in the value of a portfolio. The VAA strategy’s MDD over the past half-century was 17% – almost half the 60/40 benchmark’s 30%.

What’s the opportunity here?

VAA has an impressive track record: it has generated excellent investment returns both on an absolute and risk-adjusted basis. Part of the reason VAA managed to avoid big investment drawdowns is its use of absolute momentum: when any offensive asset starts to show signs of weakness, the strategy shifts to safer assets, like bonds.

All in all, if you apply this strategy to your investments, you may well boost your returns. Having said that, the old investment adage – “past performance is no guarantee of future results” – applies here: the VAA strategy may not necessarily perform well in the future and/or may experience a bigger peak-to-trough loss of 17% at some point.

What are the risks involved?

The strategy’s high volatility means it’s not for the faint of heart. And VAA has two drawbacks on top of that. First, it moves into bonds when any of the offensive assets start exhibiting negative momentum. This reliance on bonds has worked well in the past considering the decades-long bond bull market. But going forward, it’s unrealistic to expect bonds to offer the same sort of strong returns as they did in the past.

Second, the strategy is the exact opposite of diversified: it holds a very concentrated portfolio invested in a single ETF. In practice, you should rarely ever invest your entire portfolio in a single fund – so I wouldn’t recommend you implement VAA in isolation. But you could, perhaps, use it for the equity portion of your portfolio. Let’s say 30% of your portfolio is invested in a few stock market ETFs targeting different geographies. You could swap out that allocation for VAA: the strategy is, after all, trying to target the best-performing geographies while switching to bonds when it senses trouble.