This caught my eye as I searched for some more academic research on my favorite risk measure drawdown.

Yang, Z. George and Zhong, Liang,

*Optimal Portfolio Strategy to Control Maximum Drawdown – *

The Case of Risk Based Dynamic Asset Allocation (February 25, 2012).

Available at SSRN: http://ssrn.com/abstract=2053854 or

http://dx.doi.org/10.2139/ssrn.2053854

The paper seeks to do what I have tried to do without any real success—use drawdown to help determine position size. I felt motivated to replicate in R their measure Rolling Economic Drawdown-Controlled Optimal Portfolio Strategy (REDD-COPS). Since drawdown suffers from a significant lag, the authors suggest a rolling drawdown to offset some of the embedded lag:

“Intuitively, a drawdown look-back period H [length of rolling period] somewhat shorter than or similar to the market decline cycle is the key to achieve optimality. Substituting EDD with a lower REDD in equation (1), we have higher risky asset allocation to improve portfolio return

during a market rebound phase. In the examples followed, we’ll use H = 1 year throughout.”

The authors calibrate REDD-COPS on the S&P 500 as a single asset, and then use REDD-COPS in a portfolio context with three assets (S&P 500 – SPY, US 20+ Year Treasury – TLT, and DJ UBS Commodity Index). I’ll show the results from my attempt to replicate the single asset test. Sorry for the Thanksgiving but ugly colors, but I just could not resist.

Their results are interesting, but I’m not entirely convinced of the robustness of a system using REDD-COPS to determine position size especially since their use of entire period Sharpe requires hindsight. However despite the ultimate result, the byproduct discovery discussed in my post Cash–Opportunity Lost or Opportunity Gained was well worth the effort. Stay tuned for my attempt to do the multi-asset REDD-COPS system.

R code in GIST:

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