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Guido Giese derives a model for the performance and risk analysis of algorithmic
investment strategies that invest in a mixed portfolio of the equity and money
markets. It is based on a frequent rebalancing algorithm that responds to changes
in volatility of the underlying equity market using a pre-defined response function.

logorithmic investment schemes that invest investor saving for his retirement.
in a frequently rebalanced portfolio of equity Further, the basic idea to shift investment between the
and fixed-income have become more common risk equity market and a safe fixed-income investment has
in recent years. Some are even available to led to the development of portfolio insurance investment
retail investors, through index-tracking models (see Perold & Sharpe, 1995) that rebalance the
products. One can distinguish between two basic types of portfolio to ensure a certain minimum capital protection
existing investment schemes: pure return strategies, such as level.
leveraged index-based exchange-traded funds (ETFs) that In this article, we analyse rules-based rebalancing
borrow in the money market to offer leveraged equity investment schemes from a pure expected return and
returns for risk-seeking investors; and risk-controlled expected Sharpe ratio perspective, without referring to an
strategies for risk-averse investors, which shift part of the arbitrary utility function or time horizon or capital
equity investment into the money market during periods of protection level. We are interested in creating investment
high volatility to protect the investor from serious losses. schemes that can easily be tracked and issued in the form of
In this article, we analyse strictly rules-based investment retail investment products such as ETFs or certificates where
schemes that combine positions in equities and money optimising the performance or the risk-return profile is the
markets, where we typically assume an equity investment in dominating investment target.
the form of a liquid index to ensure the investment scheme The structure of this article is as follows: first, we derive
can be replicated and traded in a cost-efficient way. Further, a general model description for investment strategies that
we allow the equity and money-market positions to be either frequently rebalance between an equity and money-market
long or short to allow leveraged, de-leveraged and short investment, using equity volatility as an input parameter.
trading strategies. The key results are expressions for the expected return and
We focus on investment schemes that use equity market expected Sharpe ratio of the investment scheme. Then, we
volatility as a key input factor in determining the size of the analyse existing strategies (that is, leveraged and risk-con-
equity investment and to trigger a rebalancing between it trol strategies) before we derive the optimal rebalancing
and the money-market investment. The reasons for using strategies for return-maximising and risk-return maximis-
volatility as a key allocation factor are twofold: ing investment schemes. We will give a mathematical proof
There is a strong negative correlation between the that these optimal strategies have a higher expected return
performance of equities and equity volatility, that is, falling or higher expected Sharpe ratio than the underlying equity
equity markets typically coincide with rising levels of investment, irrespective of the chosen equity index. We
volatility and vice versa. This has led to many volatility-driv- therefore argue that these strategies are algorithmic alpha
en products in the market. strategies. Finally, we add empirical evidence to the
It has been shown (see Despande, Mallick & Bhatia, 2009, mathematical proofs of superior returns and superior
Cheng & Madhavan 2009, and Giese, 2010) that frequently Sharpe ratios for bespoke optimised strategies.
rebalancing investment schemes between equity and
fixed-income suffers from rebalancing losses that are Model description
proportional to the variance of the underlying equity index, We assume a liquid underlying equity index St to model the
as we will also show later in this article. Therefore, using the equity investment of our investment scheme that follows a
volatility of the underlying equity market as an input factor stochastic process with growth rate u and stochastic volatility
for the asset allocation is essential to minimise the adverse st:
effects of rebalancing.
dSt = St (udt + σ t dWt ) (1)
Rules-based mixed equity and fixed-income investment
schemes have been analysed in the literature before in where Wt denotes a standard Wiener process with constant
several different contexts. The first and influential contribu- drift u. As a general investment concept, we consider an
tion of Merton (1971) was based on an investor who investment strategy It that uses volatility as an asset
maximises a pre-defined utility function on a fixed time allocation signal in the sense that it invests a proportion of
horizon, which resembles the decision problem of an R(stm) into the underlying equity index St and 1 – R(stm)

34 ETF Risk: July 2012