Finvex has published a research paper on the Margrabe best-of-two (MBo2) strategy, a rule-based dynamic investment solution for the two-asset allocation problem. The strategy, which involves yearly rebalancing the portfolio weights to 50-50 between a high-risk and low-risk asset, uses intra-year weight adjustments to chase the momentum of the best performing asset by replicating the value of a Margrabe option to exchange an asset for another asset.

The most important decision investors have to make is the asset allocation, according to Stefan Hartmann (pictured), head of quantitative research, Finvex. "If you think about it, many research departments have like 200 analysts and they will do stock selection and try to pick the best stocks," said Hartmann. "However, if you get the asset allocation wrong, for example overweight equities at the wrong time, or the other way round, then it is very difficult to generate performance. In that sense, for all the funds, the biggest performance contribution is the asset allocation and that's why we came out with this paper."

The MBo2 portfolio allocation offers portfolio protection by timely shifting to a low risk asset, and, according to Hartmann, the big idea is similar to a constant proportion portfolio insurance (CPPI) strategy. "What we try to achieve is that we have two assets, in this case equities and bonds, and you want them, ideally to be negatively correlated, so that in one market environment equities would be successful while in another market environment bonds would be successful," said Hartmann. "If there is an equity market sell-off, then you want to have an alternative asset and it would make sense to have two assets that have a very high negative correlation. Basically, the idea is, you want to end up every year with the asset that has the highest performance."

The strategy, which is rule-based and thus excludes behavioural biases, uses option-based theories to progressively invest more in the best performing asset. "If, for example, initially, the equity market goes up, then the chances at the end of the year of equities outperforming bonds have risen," said Hartmann, noting that, based on that probability, the exposure to equity would be increased. "So if the equity market continues to go up, say we are now in December and the equities market have gone up 15%, and the bond market has gone up 5%, the chances that the bond market will outperform is basically zero, and in that scenario we would be 100% invested in equities."

According to Hartman, "if you have a bond year, when the equity market sells off and goes down 20%, and bonds make 1% performance by mid-year, then it would be quite difficult for the equity market to recover and that kind of scenario you would be 90% invested in bonds".

Additionally, if you are quite certain equities will outperform you allocate a high portion of your portfolio in equities, according to Hartmann. "If it is the other way round, if equities are really doing poorly, say the year 2001/2002 you basically will have no equities and you will be 100% invested in bonds. So if the market goes one way or the other way, this strategy works really well. In really good equity years, you will capture 90 to 95% of the equity market performance and in really bad years you will have the bond market performance," said Hartmann.

However, investors might lose switching cost, which, according to Hartmann, is going to be in the range of 5%-10%, "so the minimum return is very much defined". "Rebalancing costs depends on the realized volatility," said Hartmann who admits that this is the problem with any option strategy. "After the price has gone up you tend to buy and then if the market goes the other way you sell. So you always buy at the higher price and sell at the lower price and all those transactions cost you money."

According to Hartmann, the worst scenario for this strategy is if the market can't define if it is going to be a bond year or an equity year. "If you have this kind of side-ways market, the strategy underperforms the best performing asset class in this scenario. But the other way round, if there is a clear winner, either bonds or stocks, you will be very close to the performance of the best performing asset.

The MBo2 strategy makes sense for any combination of uncorrelated assets, not just bonds and equities, and could also be applied to the pair gold and the equity market, according to Hartmann. "[In this case] gold is more a safe asset, while the equity market is more a risky asset," he said.

"This is an interesting product for any pension fund or longer term investor," said Hartmann who thinks too much attention is often paid to picking the right stocks in long only portfolios. "If you have exposure to the equity market at the wrong time it will be very hard to outperform a classical equal weighted stock/bond portfolio. In an equity portfolio with 50 stocks or more, 80-90% of your risk will be explained by market beta, and only 10% is stocks specific. So if you get the market timing wrong, then there is no way to outperform."

Click the link to view the full research paper: The Margrabe best-of-two strategy: a sweet spot between equity upside potential and resilience to equity downturns.

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