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Monday, January 12, 2015

ETF Rotation Systems to beat the Market - Global Equities

This is the second chapter of the ETF Rotation Systems to beat the Market series. If you want to know what this is all about,  you may want to read the Introduction here.

On the previous chapter I showed you a simple ETF Rotation System purely based on American Equities. We saw how it out performed the SPY while being less volatile which are the two main goals of ETF Rotation systems.

However, given the nature of the markets and the constant uncertainty about the future, being invested on a single country for long periods of time poses significant risks. While we know that the US Markets have grown about 7% a year on average for the last century, there is absolutely no guarantee that this will continue to be the case going forward. The risk of being invested in equities of a single geographic area can be clearly exemplified with the case of Japan.

The Nikkei 225 Index made an all time high of 38,957.44 on December 29, 1989.
Today, more than 25 years later, the index is trading at 17,197.73. Yikes!

Had you been invested on Japanese equities these last 25 years you wouldn't have done much to help your retirement cause. In fact you could have quite possibly hurt yourself pretty badly.

Will the same thing ever happen to the US Markets? Probably not. But can anyone guarantee it? Absolutely NOT. Because nobody knows anything. Japan was the second most powerful economy in the universe, a very important nation with over 100 million people, a country full of pretty smart individuals,...yet this is what happened to their markets. If you invest on an ETF Rotation System based purely on American equities and something similar happens to the American Markets, it doesn't matter how much you rotate or what the hell you do with your 100% equity portfolio: You will have negative returns.

But one thing that tends to happen in this life, is that almost always, when somebody is doing badly, there are others taking advantage of that and doing much better. For example, when the price of Oil is high, the economies of net Oil importers suffer, however countries like Canada and Russia flourish. Viceversa when Oil goes to cheap extremes. When a country has a hugely negative trade balance with another nation, one of them is screwed, but the other one is usually doing better, and so on. It is more likely for one country to be doing badly than it is for the entire planet to be doing badly at the same time. There are extreme cases such as the 2008 financial crisis, but even then there were countries that comparatively did much better. For example Canada didn't need to bail out its banks and didn't even suffer a housing crash back then. We can mention several examples related to other commodities and other countries or entire geographic regions, but you get the idea.

For this reason if you are going to use a 100% equity based portfolio, a Global Equities ETFs Rotation system is stronger and has better chances of long term survival than the American Equities ETFs Rotation system seen on the previous chapter. With that in mind, we'll simulate a Global Equities portfolio that rotates its capital among the following 5 ETFs:

EEM: iShares MSCI Emerging Markets Indx (ETF)
EPP: iShares MSCI Pacific ex-Japan Idx (ETF)
IEV: iShares S&P Europe 350 Index (ETF)
ILF: iShares S&P Latin America 40 Index (ETF)
MDY: SPDR S&P MidCap 400 ETF

The choice of these instruments comes from an article I read on Seeking Alpha in late 2013.

Every month, the system ranks these 5 ETFs and moves the capital to the 2 best performers. The formula to evaluate the ETFs was discussed in the Introduction of the series.

50% of the portfolio goes to the best performer, 50% of the portfolio goes to the second best performer. If the best ETFs are the same of last month, no new trades are made and the portfolio remains invested in them, enjoying the ride.

If one of the selected best performers is trading below its 10 month moving average, its portion of the portfolio goes to cash or alternatively very short term treasury bonds via SHY. If both are trading below their 10 month Moving Average the entire portfolio goes to SHY. This is to avoid turbulent periods in the global economy.

Here are the results from 2003 to 2014:
Definitely better than the S&P500 and less volatile:
CAGR: 17.2% vs 9.5% SPY (better yearly returns)
Volatility: 17.6% vs 19.5% SPY (less volatile)
Worst draw-down: -22.2% vs -55.2% SPY (smaller draw-down)
Sharpe ratio: 0.85 vs 0.44 SPY (Superior risk-adjusted performance)

Not too shabby! The Global ETFs Rotation system has delivered a Compound Annual Growth Rate of +17.2%. Its maximum draw-down was -22.2%, way lower than the -55.2% posted by SPY. In 2008, when the world was falling apart, this system delivered a -0.4% return while the SPY posted -36.8%.

Obviously it is not a perfect system, and still too volatile an equity curve for many, myself included. In future articles I will explore other systems and will start to diversify with asset classes other than equities. We will see interesting portfolios with similar returns and much smoother equity curves.

Stay tuned!

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



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2 comments:

  1. Very interesting article! During market corrections, have you ever considered to invest in a short ETF, like SH, instead of buying bonds via SHY?

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    Replies
    1. Thanks Thomas. I have indeed tried using inverse ETFs (For readers these are ETFs that go up as the markets go down). Surprisingly Thomas, I haven't been able to obtain significant improvements from them.

      Cheers,
      LT

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