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

Abstract

This article presents several active strategies for combining value and momentum strategies in a tactical asset allocation (TAA) framework. It refines the basic yield approach to valuation by standardizing the value signal using the Z-score. Such standardization not only enables the authors 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. It improves the momentum strategy by considering both relative and absolute performances. In the combined TAA model, this modification to momentum acts as a simple mechanism to adjust the importance of value and momentum strategies under different market conditions. The combined model takes advantage of both short-term momentum effects and long-term mean-reversion in valuation to achieve superior overall portfolio performance. Finally, it also provides alternative models for smaller tracking errors.

TOPICS: Analysis of individual factors/risk premia, portfolio construction, performance measurement