- ETF Rotation Systems to beat the Market - American Equities
- ETF Rotation Systems to beat the Market - Global Equities
- ETF Rotation Systems to beat the Market - American Equities + TLT + GLD + IYR + EEM
- ETF Rotation Systems to beat the Market - SPY + EFA + IEF + GLD + ICF
Today we are going to take the concept of diversification a little farther. We will exploit the idea of the fourth chapter materialized in the SPY + EFA + IEF + GLD + ICF portfolio. That is, we will create a portfolio that uses the same asset classes: Equity (US), Equity (International), Bonds, Real Estate and Commodities but this time we will choose two symbols for each category instead of just one.
These are the ETFs of choice:
SPY - SPDR S&P 500 ETF Trust
IWM - iShares Russell 2000 Index (ETF)
EFA - iShares MSCI EAFE Index Fund
EEM - iShares MSCI Emerging Markets Index
TLT - iShares Barclays 20+ Yr Treasury Bond
TLH - iShares Lehman 10-20 Yr Treasury Bond
DBC - PowerShares DB Com Index Tracking Fund
GLD - SPDR Gold Trust
ICF - iShares Cohen & Steers Realty Maj.
RWX- SPDR Dow Jones International Real Estate
Let's analyze the system when it invests in the two best performers each month. 50% of the capital goes to each one of the two best ETFs. The formula to evaluate the ETFs was discussed in the Introduction of the series. The system is always 100% invested. No cash position.
Here are the results:
(Click on image to enlarge)
Volatility: 15.3% vs 19.5% SPY
Worst draw-down: -13.8% vs -55.2% SPY
Sharpe ratio: 1.06 vs 0.44 SPY
This is a great result. 18.8% Compound Annual Growth Rate for a 12 year back-test period is nothing to sniff at. Let alone with a maximum draw-down of only 13.8%.
Now, let's do another test but instead of investing in the 2 best ETFs each month, the system will invest in the best 3 ETFs each month. 33% of the capital will go to each one of the selected ETFs. Again the portfolio remains 100% invested at all times. No cash position. In a pool of 10 instruments to select from, choosing 3 shouldn't cause a huge loss of performance as the third best ETFs should still be a pretty good one. I would also expect less volatility, more stability in the equity curve over time. Let's see:
(Click on image to enlarge)
Volatility: 13.5% vs 19.5% SPY
Worst draw-down: -16.5% vs -55.2% SPY
Sharpe ratio: 1.22 vs 0.44 SPY
Nice improvement in terms of Compound Annual Growth Rate. The volatility of the portfolio also decreased but the worst draw-down was a bit higher. Still, great ETF Rotation System with an outstanding Sharpe Ratio of 1.22. I feel pretty happy with this portfolio and would trade it with my own money (if only I had more).
Surprisingly adding a cash filter rule to this system doesn't provide improvements. The filter rule, as a reminder, is the rule by which, if one of the selected instruments to be invested in is trading below its 10 month moving average, that portion of the capital sits in cash or very short term bonds (SHY). No improvements were obtained. The addition of the filter rule always decreases the returns a little bit and the goal is to see a significant reduction in the worst draw-down and the volatility of the portfolio. While it did decrease the returns, the rule didn't provide a reduction in the volatility nor the worst draw-down numbers to justify its addition.
My final take on ETF Rotation Systems and some things to consider
ETF Rotation systems have been quiet a discovery for me. What really impresses me is the fact that your particular choice of ETFs is not as important for outperforming the markets as it is to diversify your selection using different asset classes. This says a lot about how powerful the strategy is. Positive long term results will not depend on your ability to magically pick the best instruments of the future, which is great. During my hundreds of tests, portfolios seemed to always easily beat the market as long as several asset classes were used. Any portfolio of ETFs that covered US Equity, International Equity, Bonds, Real Estate and Commodities outperformed the S&P500 regardless of the specific ETFs I chose. This reinforces my confidence in the strategy. The idea in principle is solid and the particular choice of ETFs is not as determinant for your long term success as long as you are diversified across multiple asset classes.
One thing to keep in mind when designing your portfolio is the management fees of your ETFs of choice. ETFs are usually cheaper than Mutual Funds by far, but still something to look at. Obviously the smaller the management fee the better. Also, look at possible dividends. If your ETFs of choice are dividend payers then that's better. By the way all the test results shown in the series include dividends.
If you have a small portfolio, make sure trading commissions costs are reasonably controlled. For example if your ETF Rotation system chooses the 2 best ETFs each month, assume that you will make 4 transactions every month. Two in order to sell your current ETFs plus two in order to buy the best two ETFs for the next cycle. That is a total of 48 transactions per year. You may end up trading much less than that. You may find your system riding an ETF for an entire year without having to sell it to purchase another one, but when designing your system you must take into account the worst case scenario and the maximum possible number of trades per year. In this case, 4 trades per month means 48 per year. A broker charging only $5 per transaction would cost you $240. If you have a small $10,000 portfolio, that trading cost represents a 2.40% drag in the performance, which is unacceptable. Either find a broker with cheap commissions for trading ETFs or wait until you have a larger amount of money in order to implement an ETF Rotation system where your worst trading costs per year will be less than 1% of the portfolio balance.
ETFs rotation systems have great potential for outperforming a simply "long the market strategy" in the long run and to do it with less volatility and smaller draw-downs. There is plenty of evidence to support that statement.
If you want to expand your knowledge on the area of Rotation Systems and consult deeper research encompassing multiple decades of market history (even more than a century), I suggest you read A Quantitative Approach to Tactical Asset Allocation. It's an eye opener.
This is the end of the ETF Rotation Systems to beat the Market series. I hope you had as much fun reading it as I had writing it and I hope it is useful to someone out there.
Disclaimer: Data and back-testing via ETFReplay.com
For all the details on how the ranking works, read: ETF Rotation - Free Ranking evaluation tool
Interested in this Series?
Here are all the chapters:
1. ETF Rotation Systems to beat the Market - American Equities
2. ETF Rotation Systems to beat the Market - Global Equities
3. ETF Rotation Systems to beat the Market - American Equities + TLT + GLD + IYR + EEM
4. ETF Rotation Systems to beat the Market - SPY + EFA + IEF + GLD + ICF
5. ETF Rotation Systems to beat the Market - SPY + IWM + EEM + EFA + TLT + TLH + DBC + GLD + ICF + RWX