Pair-switching refers to investing alternatively in two negatively correlated assets on the basis on their recent performance or any other appropriate criterion. The evaluation of the criterion and the decision to switch (or not) is generally taken monthly or quarterly. Pair-switching is fundamentally different from pair-trading, which at the opposite deals with two strongly correlated assets and tries to exploit discrepancies in their behavior.
When the criterion of pair switching is the total return on a recent period (or a combination of total returns on recent periods), it falls in the category of momentum strategies.
The easiest way is to take a stock index ETF and a T-Bond ETF as negatively correlated assets. The next table shows simulation results with the following hypotheses:
- Starting on 8/1/2002 (because of ETF inception dates).
- One position in portfolio.
- The ETF with the highest return of both last 60 days is chosen.
- Rebalancing every 4 weeks, .
- 0.1% trading fee.
Total Return: Reinvesting capital, plus gains, minus losses, plus dividends at each decision point.
CAGR: Compound Annual Growth Rate (annualized average return).
DDM: Maximum Drawdown.
Sortino: Sortino Ratio, a risk adjusted performance indicator (higher is better, above 1 is very good).
|ETF Pair||Total Return||CAGR||DDM||Sortino|
The table shows that all indexes are not equal. With the Midcap ETF (NYSEARCA:MDY), the return and Sortino ratio are impressive for a so simple strategy. The current position is MDY on publication date.
On the same period, the annualized return of holding MDY and TLT (NYSEARCA:TLT) were respectively 9.89% and 8.14%, with maximum drawdowns of -55.37% and -27%. This is a coincidence, but we note that the average return of the strategy is almost exactly the sum of both separate average returns. It means that this strategy did as well as leveraging twice an equal weight portfolio of MDY and TLT, before taking into account the borrowing rate. With the difference that holding MDY and TLT would have lead to a -46% drawdown. This is twice the pair switching maximum drawdown, and unacceptable on a leveraged portfolio.
A monthly strategy may be very sensitive to starting dates. This is not the case here. With four starting dates separated by a one-week interval, the return stays between 17.8% and 22%, and the drawdown between 18 and 27%. You may want to Click here for more information about our research.