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Friday, January 16, 2015

ETF Rotation Systems to beat the Market - SPY + EFA + IEF + GLD + ICF

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

In the previous chapter we started to diversify the portfolio by adding other asset classes into the mix. The American Equities + TLT + GLD + IYR + EEM portfolio delivered some very interesting results in terms of both performance and draw-downs for 12 years of back test. With such encouraging results we inevitable start to wonder, how far can this go?

How much better can things possibly get from here? After all, profitability can only be stretched so much before we add excessive risk or start curve-fitting the system to past known data.

I'm mentioning this because I have seen a number of ETF Rotation systems discussed in different places, with supposedly 30%, 40% even 60% yearly returns. To me that's all absurd. Most of them are curve-fitted systems with an excessive number of rules and a good portion of them if not most, are made up of young ETFs with no more than 3 - 5 years of history. Of course a 3 - 5 year back test can show you a 40% Average Yearly return on an ETF Rotation system. But that's almost unequivocally an anomaly that should correct itself over time. Even the system discussed in the previous chapter had a 21% yearly return from 2009 to 2011. But that's only part of the history. 3 years should create no illusion at all in the minds of savvy investors.

By now I have experimented with a bunch of combinations of instruments and probably ran close to a thousand back tests or more. I was only able to create one portfolio with a greater than 20% yearly return for the entire 12 year period, which is as far back as goes. And that portfolio was pretty aggressive and had to endure a -25% draw-down to achieve those results. I won't discuss it in the series as I don't think it is that interesting.

Now you know you won't find the holly grail in this series of articles. But that won't stop me from trying to refine the systems and improve statistics such as the volatility of the portfolio, the worst draw-down and the risk-adjusted performance (Sharpe Ratio). For more information on the Sharpe Ratio visit this link.

Today we are going to simulate a portfolio with only 5 instruments but a solid degree of diversification. This portfolio is good for small accounts as the number of trades per year is smaller than the 13 instrument portfolio analyzed in the previous chapter. This reduces the impact of commissions as you have to get in and out of positions less frequently. The portfolio only selects the two best performers every month (instead of 3) which makes it even less active. The formula to evaluate the ETFs was discussed in the Introduction of the series.

These are the instruments of choice:

SPY: SPDR S&P500 Index (US Equity)
EFA: iShares MSCI EAFE (International Equity)
ICF: iShares Cohen&Steers Realty REIT (Real Estate)
IEF: iShares Barclays 7-10 Yr Treasury (Medium term Bonds)
GLD: SPDR Gold Trust

Here's the result from 2003 to 2014
(Click on image to enlarge)
CAGR: 18.3% vs 9.5% SPY
Volatility: 12.9% vs 19.5% SPY
Worst draw-down: -22.2% vs -55.2% SPY
Sharpe ratio: 1.18 vs 0.44 SPY

This is the first portfolio in the series with a Sharpe Ratio above one, which is excellent. Great yearly return at 18.3%. Even though the worst draw-down was a bit high at -22.2% the equity curve was very stable showing a volatility of just 12.9% in the 12 year period.

Here are the returns per year:
(Click on image to enlarge)
This portfolio looks solid just as is. But just out of curiosity let's apply the filter rule. Again, if a chosen instrument is below its 10 month moving average, its corresponding 50% of the portfolio goes to cash or SHY. If both chosen instruments are below the 10 month average the entire portfolio goes to cash.

(Click on image to enlarge)
CAGR: 16.8% vs 9.5% SPY
Volatility: 11.8% vs 19.5% SPY
Worst draw-down: -12.6% vs -55.2% SPY
Sharpe ratio: 1.19 vs 0.44 SPY

These are serious numbers. A 16.8% yearly return with a worst-draw-down of only 12.6% and an equity curve with an 11.8% volatility is as good as it gets. So good that it makes me question if it will continue like this in the future, or if the data source is correct lol. But that's what the back test says.

Here are the returns per year:
(Click on image to enlarge)
Both versions of the portfolio (with and without the filter rule) have underperformed SPY in the last 3 years. This is due to the fact that SPY has been really strong in that period, but that will change in the future. There's no way the S&P500 will keep delivering double digit returns forever.

On a side note, some people have asked me why not select only the best instrument. Others have asked me why not the best 4 or 5 in the case of a large selection of instruments.

The answer to the first question is simple, having the entire portfolio invested in only one instrument makes it way more volatile as the back tests I have run clearly show over and over again. On the other hand, choosing too many vehicles leads to a situation where you invest in some that are not stellar, but just "good" which tends to cause a decrease in the returns. For example in the portfolio analyzed today, choosing only the best instrument each months leads to greater volatility and choosing the best 3 instruments out of 5 inevitably leads to smaller returns. It would be too boring to show 6 back tests here and would make this article extremely long, which it already is by the way.

Thanks for reading and stay tuned for the last portfolio to close off the series.

Disclaimer: Data and back-testing via

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. I have read all the articles in this series. I am very interested in doing this ETF Rotation trade with you. When do we start?

    1. Haha, I think I'm doing too much already my friend. I need to raise some capital first before I introduce another strategy. But if you want more info on the formulas etc send me a private.