Using a Z-score Approach to Combine Value and Momentum in Tactical Asset Allocation

Abstract

We present several active strategies for combining value and momentum strategies in a tactical asset allocation (TAA) framework. We refine the basic yield approach to valuation by standardizing the value signal using the Z-score. Such standardization not only enables us to directly compare valuation measures across asset classes, but also offers insight about each asset class’s absolute valuation by its own standard. Under the nonlinear approach, it helps to identify market peaks and bottoms. We improve the momentum strategy by considering both relative and absolute performances. In the combined tactical asset allocation model, this modification to momentum acts as a simple mechanism to adjust the importance of value and momentum strategies under different market conditions. Our combined model takes advantage of both short-term momentum effects and long-term mean-reversion in valuation to achieve superior overall portfolio performance. Finally, we also provide alternative models for smaller tracking errors.