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Tuesday, January 13, 2015

ETF Rotation Systems to beat the Market - American Equities + TLT + GLD + IYR + EEM

Welcome to the third chapter of the ETF Rotation Systems to beat the Market series, where we explore different ETF Rotation portfolios and their potential to outperform the markets and do it with less volatility and smaller draw-downs. If you haven't done so, you may want to read the previous chapters:

- ETF Rotation Systems to beat the Market - American Equities
- ETF Rotation Systems to beat the Market - Global Equities

So far, we've only discussed systems whose instruments belong to one single asset category: Equities. The Global Equities rotation system delivered a solid +17.2% Compound Annual Growth Rate for over a decade. But it was still pretty volatile (17.6% volatility) and its worst draw-down at -22.2% would have had many investors screaming for the exit. That's what happens with equities: the asset class that over time delivers the best returns is also the most volatile one. Although the yearly return of the portfolio was solid, we need to address the volatility on that equity curve and also that worst draw-down value. We'll address that by exploring the benefits of diversifying the portfolio with other components such as Bonds, Real Estate and Precious Metals.

To illustrate the benefits of using different asset classes, I'm going to use the exact American Equities portfolio discussed on the first chapter but I will add TLT (Bonds), GLD (Gold), IYR (Real Estate) and EEM (Emerging Markets) to it. This is the entire selection of instruments:

XLB: U.S. Materials Sector SPDR
XLE: U.S. Energy Sector SPDR
XLF: U.S. Financial Sector SPDR
XLI: U.S. Industrials Sector SPDR
XLK: U.S. Technology Sector SPDR
XLP: U.S. Consumer Staples Sector SPDR
XLU: U.S. Utilities Sector SPDR
XLV: U.S. Health Care Sector SPDR
XLY: U.S. Consumer Discretionary Sector SPDR
TLT: iShares Barclays 20+ Yr Treas.Bond (ETF)
GLD: SPDR Gold Shares
IYR: iShares Dow Jones Real Estate REIT
EEM: iShares MSCI Emerging Markets

I added International equities via EEM so as to diversify the equity exposure to markets outside the US. We saw the benefits of that in the previous chapter. Every month, the system ranks these 13 ETFs and moves the capital to the best 3 performers. The formula to evaluate the ETFs was discussed in the Introduction of the series.

For the first simulation, the system will always be invested. By that I mean, no cash position. Every month, one third of the capital is invested in one of the three best performers, so the portfolio remains 100% invested at all times. Here's the result from 2003 to 2014:

(Click on image to enlarge)
Ok now we're talking!

CAGR: +15.6% vs +9.5% SPY (better yearly returns)
Volatility: 14.2% vs 19.5% SPY (less volatile)
Worst draw-down: -18.2% vs -55.2% SPY (smaller draw-down)
Sharpe ratio: 0.92 vs 0.44 SPY (Superior risk-adjusted performance)

The improvements over the simple American Equities Rotation system are huge with the addition of Bonds, Gold, Real Estate and Emerging Markets. No doubt those were healthy additions. This new system in my eyes is also better than the Global Equities rotation system discussed in the previous chapter. The equity curve is way easier to ride. The volatility of the system is 14.2% vs 17.6% of the Global Equities rotation system. The worst draw-down at -18.2% is still not ideal but better than the -22.2% of the Global Equities portfolio. The Sharpe ratio is also the best we've seen in the series so far with a solid 0.92.

These are the returns of the portfolio broken down per year:
(Click on image to enlarge)
This portfolio didn't have a single negative year in the entire back test, not even 2008 where it was invested in Gold and Bonds almost all the time.

Let's now apply our filter rule. If any selected instrument (among the best 3 for the month) is below its 10 month moving average, that third of the portfolio goes to cash or a proxy like SHY (very short term bonds). The goal is to avoid times of turbulence by going to a conservative instrument.

(Click on image to enlarge)
This is certainly an interesting result:

CAGR: +14.2% vs +9.5% SPY (better yearly returns)
Volatility: 13.1% vs 19.5% SPY (less volatile)
Worst draw-down: -13.0% vs -55.2% SPY (smaller draw-down)
Sharpe ratio: 0.90 vs 0.44 SPY (Superior risk-adjusted performance)

Comparison of the portfolio with and without the filter rule:

As expected, the version with the filter rule was less volatile. Obviously at the expense of some reduction in the annual returns. The reduction in the worst draw-down statistic was significant and a 13% draw-down is something that many investors can digest. With a greater than 1 ratio of CAGR/Max Draw-Down this is a remarkable result. The filter rule didn't do much to improve the risk-adjusted performance a.k.a Sharpe Ratio.

Which version of the system is better is up for debate. The 1.40% performance difference of the first version becomes significant when compounded over time, that is if you can sleep well with a portfolio that is a little bit more aggressive and volatile. The smaller worst draw-down of the second version is certainly very attractive on the other hand while still averaging returns far superior than the market. I guess this decision is up to the investor based on his own personality and risk tolerance.

This is the third ETF Rotation system of the series. Two more to go.

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

Go to the bottom of this page in order to see the Legal Stuff


  1. Much appreciated insight - what day of the month are you rebalancing? On the first trading day?

    1. Hi Adamchik,

      Good question. The magic happens on the close of the last day of the month. For example on January 31, at the close of the market, the system would move the capital to the best performers.

  2. Thanks very much - did you look at owning 3, 4 or 5 or other numbers of ETFs for optimized returns?

    1. I did Adamchik and the returns were inferior once you start adding not only the "stellar" instruments but also the "not so bad" ones. Portfolio returns decrease over time.