
some index-makers only realign according to a set schedule.Others re-jigger as it suits them.Thus the indices enjoy an upwards boost from survivorship.The index shouldn’t drop to zero unless whole segments of themarket collapse. That obviously doesn’t mean that a stockindex can’t make a severe drawdown, it just means that it isextremely unlikely to go out of business entirely.Another advantage of index funds is that you don’t spend timestock-picking. Maybe even more important to some people, isnot second-guessing themselves over stock picks.At the Mercy of the Index-MakersWhat helps indices, and the companies in them, is that they areso widely followed. Individual companies benefit frominclusion in an index because everyone investing with indexfunds brings a higher level of sponsorship to the companiesthat comprise the index. This is no secret.For example, on August 29, 2012, Sears was removed fromthe S&P 500 because it was deemed that its public float wasnot up to snuff. LYB was chosen as the replacement with noreason given. The news was announced before the marketopened and at the open SHLD was down 4% while LYBjumped the same amount. The next day, SHLD, left to fendfor itself, dropped 0.13%. LYB immediately got in line withits new brethren and closed up 0.47% compared to SPY 0.44%gain on the day.Tracking the two days surrounding one index change does notconstitute a comprehensive study. I just bring it up to illustratethe point. Apparently the market makers believed 4% was thevalue of being included in the S&P 500 index. 4%! Nowonder few active fund managers can beat the index!The not-so-good news is that we still haven’t gotten awayfrom people picking stocks. There is no God-given list ofcompanies that make up each index. Instead there are sets ofrules and committees of people that pick the companies that goin or out.
The proponents of index funds made a great case that peoplehave difficulty picking stocks that go up. Unfortunately, thatcase applies to the index too! Warren Buffet once remarkedthat when the tide goes out, we get to see who is swimmingnaked.The implicit stock-picking methods of the index-makers lookgood now, while index-following is favored by institutionaland individual investors alike. Should indices fall from favor,the story may be different.For now, it seems reasonable to follow the herd following theindices. Just stay alert to scandals that may cause a stampedeaway from indexing.
How to Create a Diversified PortfolioThis chapter defines a basic diversified buy-and-holdportfolio. Because the portfolio may turn out to be thebedrock of your investment strategy, the basic steps forcreating and maintaining a diversified portfolio are laid out.Why Use a Diversified Portfolio as a Reference forComparisonThe difficulty with using any one index as the baseline forcomparison is that sometimes it represented the market well,other times not. In other words, sometimes it was the place tobe, other times not.Those who know we don’t know in advance which asset classwill do well often hedge their bets by diversifying theirportfolio across many asset classes. Stocks, bonds, and realestate are the three primary choices. Of course, commodities,convertibles, and venture capital can be added to the mix,particularly for high net worth individuals. Index funds nowmake that easy for anyone to dabble in all the categories.The two main advantages of using a diversified portfolio asour baseline for comparison are that it sets a high standard tobeat and enables us to learn more about the basic skill ofportfolio management.Also, by choosing a referenceportfolio of index funds, we can make a direct comparisonbetween the static buy-and-hold approach and strategies forrotation among the asset classes.Altering the composition of the portfolio becomes the basis forrisk-on / risk-off. Risk-on is achieved by adding more of theasset types deemed as risky-but-rewarding during situationswhere we have reason to believe taking on the risk will pay offmore than usual. Risk-off is achieved by reducing the riskyassets and emphasizing the asset classes believed to carry lessmarket risk.“Risk-on / risk-off” connotes extremes of being completely inor completely out of the market. While that is sometimes thecase, it is perhaps more often advantageous to hedge our betsbecause
Markets have a random component and really anythingcould happen.Signals are mixed and murky most of the time.Distinct markets may be relatively uncorrelated much ofthe time, e.g. stocks and bonds.A hard-core risk-on / risk-off which yanks funds completelyout of the market became fashionable after repeatedly findingthat in market crashes everything plummets together. Forexample, commodities and stocks may move independentlymuch of the time. However, once the margin calls kick induring a crash, commodities and stocks race each other to thebottom. Later volumes in the Beat the Crash series of bookswill explore indicators to detect when to get completely out ofthe market.What Asset Classes to Include in the Model PortfolioStudies2 show that the choice of asset classes can make a bigdifference in returns down the road. History records howvarious asset classes performed in the past and that’s onefactor to consider. Knowing that PAST PERFORMANCEDOES NOT GUARANTEE FUTURE RESULTS, let’s tune into our individual goals to help with the decision.My goals for this book are to create a basic model portfoliothat everyone can understand and use for comparisonpurposes.If you’re at a place financially where you are readinginvestment books, you probably have a good-sized nest egg toinvest, and you probably own real estate. Any financialadvisor would also tell you that you need a cash account foremergencies. Therefore, I am keeping those out of the modelportfolio, even though I think it’s a good idea to hold somecash and real estate, and in fact I do both.My personal situation is that I’ve got a fair amount of goldtucked away in a bank vault – a legacy from dark daysfollowing a perma-bear advisor. So, as with real estate, I don’t
have the need to represent commodities in my portfolio. (Yes,I agree it would be better to have a diversified set ofcommodities but I’m not there yet.)Your goals will be different than mine. Consider yoursituation carefully when deciding on your own portfolio. Formore background information on portfolio management, seethe Reading List.The assets I chose for a well-rounded Model Portfolio are:
US Large-Cap StocksUS Small-Cap StocksInternational Developed Markets StocksInternational Emerging Markets StocksUS BondsTactics for Implementing a Diversified PortfolioTo implement the portfolio, we have the following choices:
Hold individual stocks, bonds, real estate in a mix thatcorresponds to the recommended split between domesticand international markets.Rely on a fund manager to pick individual instrumentsthat represent each asset class.Rely on indices that track the stock, bond, and real estatemarkets. This choice can be implemented with eitherMutual fundsExchange Traded Funds (ETFs)Recognize that owning a house and maintaining a reserveaccount for its upkeep probably more than satisfies therequirements for real estate and cash in the portfolio.Then only the stock and bond portions need to berepresented by mutual funds or ETFs.For the purpose of backtesting, it makes sense to use mutualfunds to capture the most history and ETFs to model what an
active investor might actually use. However, for your actualportfolio, you might want to consider the trade-offs.The advantages of index funds – whether they are ETFs ormutual funds – was outlined in the previous chapter (HowIndex-Makers Rule ).The advantage of owning individual stocks is that if you honeyour stock-picking techniques, you might wind up withwinners that out-perform the indices and carry your portfolioto greater glory with less tax liability. On the other hand,picking dogs or hanging onto to winners until they turn intodogs can cost you. In fact, individual companies candisappear entirely, leaving stockholders with nothing but a taxwrite-off.The advantage of owning individual bonds is that you can justhold onto them, receiving dividends until maturity when youget the principal back. Compare to bond funds where the priceof the fund changes in response to interest rates. Yes, themarket value of the bond changes over time too but you canjust ignore it if you’re intent on holding until maturity. Thedown side shows if you pick a bond that defaults on itsobligations: doesn’t pay its interest, doesn’t return itsprincipal. Bond funds make it easier to diversify againstdefaults.Matching Funds to Asset ClassesFor the backtesting reference portfolio, here’s a list of fundswhich represent the chosen asset classes. Figure 1 is easy toread at a glance. If your reader renders it in super-fine print,you can click it to bring up an enlarged version. If you lackthe patience for all of that, no worries, the choices are detailedin plain words below.
Figure 1 – Asset Classes and TickersVisit website to download all graphicsFor US large-cap stocks, the S&P 500 is the undisputedchoice. SPY, which tracks the S&P 500, is typically the ETFwith the highest volume. No one is offering to let you tradethat one for free! IVV is an ETF from iShares that tracks theS&P 500, which trades commission-free at FidelityInvestments (at the time of this writing). When implementingthe US Large-Cap stocks with mutual funds, I chose VFINX –the Vanguard fund that started it all.For US small-cap stocks, three different indices represent thespace. The Russell 2000 is probably the most popular as IWMranks among the top ETFs by volume. S&P also keeps theS&P Small-Cap 600® index. For mutual funds, againVanguard has the longest history of small-cap indexing withNAESX, which tracks the MSCI US Small-Cap 1750.For International Developed Markets Stocks, the EFAexchange traded fund tracks the MSCI EAFE® index. Rightnow, the Fidelity fund FSIIX passively tracks that same index.Unfortunately, no international fund on exactly that index hasquite enough history for backtesting. The closest match isVGTSX which does allow us to backtest from 1998 butactually follows the MSCI All Country World ex-USAInvestable Market Index. The upshot is that the modelportfolio emphasizes emerging markets a little more in mutualfunds than it does in ETFs.International Emerging Markets Stocks are tracked by the ETFfrom iShares with ticker EEM and the Vanguard fund VEIEX,
which both follow the MSCI Emerging Markets index. Notethat with these index funds, we can invest in marketsworldwide without taking the time to become familiar withtheir languages and stock exchanges.US Bonds are represented by the Barclays U.S. AggregateBond Index, which is tracked by the iShares AGG exchangetraded fund. VBMFX is the Vanguard fund counterpart. Thisbond index has a duration of 5-10 years which makes it lessspeculative than long bonds and more lively than short-termnotes. It also features a mix of corporate and treasury bonds.What Percentage to Invest in Each Asset ClassNow that we’ve decided on our asset classes, the next questionis how much to invest in each.Professional portfolios managers allocate their assets bycomputing percentages according to their model ofrisk/reward. The Nobel-Prize winning Modern PortfolioTheory (MPT)3 takes advantage of the lack of correlationamong diversified assets to create an optimal portfolio in termsof expected return for a given risk. Or, for a given risktolerance, MPT can help find the portfolio weighting thatproduces the highest expected return.As an aside, MPT relies on values for volatility, correlation,beta, and even expected return that are typically derived fromhistorical price data. It is possible to plug in truly forwardlooking expected returns, say by calculating a price asdiscounted cash flow of the underlying company but almosteveryone looks in the rearview mirror for volatility andcorrelation.Further complicating matters, professional suggestions forindividuals’ portfolios include a notion of investment horizon.They generally recommend putting more coin in stocks whenone is young and directing a greater proportion of dollars tobonds in later years when one favors stability and income.One rule of thumb is that the percentage of your portfolio inbonds should equal your age. Stock index fund proponentscall that conservative though. 4
Detailing the models is beyond the scope of this report butkeep in mind these methods result in dynamic portfolioallocations that change with the past performance of themarket and the current needs of the investor.Of course, many popular money guides give a simplistic onesize-fits-all investment allocation. For the purpose of areference portfolio, I will calculate the returns on a severaldata points and use the middle one as the baseline goingforward.Setting up the Reference PortfolioGetting started is easy. Finding the number of shares to buyfor each element of the portfolio is a simple calculation. Onthe start date, for each fund, just multiply the account balanceby the percentage allocated to the fund, and then divide by thecurrent price of the fund. Round down to get the number ofshares to buy.For backtesting, I took the closing price on the start date. Forreal execution with ETFs or mutual funds, you may not beable to get that closing price due to slippage.Slippage is the difference between the last quoted price and theactual price paid. With mutual funds, there is no slippagebecause everyone gets the same price – the Net Asset Value(NAV) at the close of trading. However, if you place an orderafter the market closes for the day, it will be filled at the nextday’s close of business, which is probably a different price.Since ETFs trade like stocks, they have a price spread betweenthe bid price and the asking price. If your quantity is large,you might absorb all the shares at the bid/ask and actuallymove the market with your order. That is slippage.Limit orders can help slippage because they specify a set pricefor the transaction. In practice with thinly traded instruments,a limit order often means waiting until the market slips farenough past the set price that the market maker can scalp aprofit by accepting your order. In some cases, the market maynot come back to your limit price, leaving you to jump in withmore slippage than if you’d just entered at the market price.
In markets with wide spreads and gentle movements, or veryfast markets, you will probably find slippage unavoidable. Idid not model slippage or commissions in the backtesting.Rebalancing to Maintain the PortfolioMy initial back-tests on portfolios — published in earlierarticle and presentations — did not include rebalancing. Itwas only after contemplating the need for rebalancing in anETF rotation strategy that I came to understand the benefits ofrebalancing and actually implemented them in my backtestingtools. Now all my portfolio simulations include rebalancing.Rebalancing is the cheat for buy-and-hold strategy advocates,allowing them to participate in more market action than simplyallocating funds one time and letting her run. It is necessarybecause the more successful assets will come to dominate theportfolio over time which wrecks the diversification. Thereason I call it a “cheat” is that it allows the buy-and-holdinvestor to take profits from assets that are up and buy intolesser performers, like a value investor might do.
Performance of Buy-and-Hold of Diversified PortfoliosFigure 2 below brings together the performance metrics fordiversified portfolios with various stock/bond balances from ahistorical simulation of mutual funds held and rebalanced from 1998– 2011.The top line lists the stock/bond breakdown. For example, 70 / 30means 70% stocks and 30% bonds. The stock allocation is splitequally for each of our previous four categories of US large-cap, USsmall cap, developed markets and emerging markets. In ourexample, the 70% allocation to stocks is split with 17.5% of the totalaccount going to each stock fund.The portfolio simulator purchased the mutual funds in thisproportion on the start date and then rebalanced on the first tradingday in January of each subsequent year. Comprehensive metrics arereported in the table. A more detailed description of the metrics is inthe chapter on How to Compare Investment Strategies.
Figure 2 – Buy-and-Hold Portfolio Allocation ExplorationVisit website to download all graphics and trade-by-tradebacktesting dataCommentary on Mutual Fund Portfolio
The array of results lets us compare the effects of adding more bondsto a portfolio. Of course, going forward the numbers won’t be thesame, but we can still learn from relative comparisons since eachexperiment in Figure 2 was run on 1998 – 2011.First off, notice that consistently across the board the max drawdown(Max DD %) decreased as more bonds were added to the portfolio.This is graphed in Figure 3. The percentage of stock vs bonds in theportfolio is marked out along the bottom. The amount of stock inthe portfolio decreases as we move left to right in the graph. Sincedrawdown is a negative number which becomes less negative asmore bonds are added to the portfolio, the line goes up and to theright in Figure 3.
Figure 3 – Maximum Drawdown of Portfolio ExplorationInterestingly enough, the CAGR also increased when going from theextreme of 90% stocks to the balanced situation of 50% stocks /50% bonds. Adding more bonds than 50% again decreased theCAGR but also decreased the max drawdown. See Figure 4.
Figure 4 – CAGR of Portfolio ExplorationThe average annual returns were consistently decreasing with lessstock in the portfolio. This discrepancy with the actual profit (row3 of Figure 2) is why average annual returns are presented in smallerprint than CAGR. The average of all the years together can obscurethe order dependency of returns (getting a profit before a loss isbetter than taking a loss then profit because in the latter case, theprofit comes on a smaller account balance). Figure 5 showsgraphically how the average annual returns changed with morebonds in the portfolio.
Figure 5 – Avg Annual Return of Portfolio ExplorationVolatility went down with more bonds – that was the point. You cansee the effect that had on the Sharpe ratio in Figure 6, whose annualvalues only got above 1 for the case of 20% stocks and 80% bonds.Clearly this was a tough time period to hold onto stocks, even with adiversified portfolio.
Figure 6 – Sharpe Ratios of Portfolio ExplorationOn the monthly statistics, the average return (in Figure 2, row 6)again decreased as the proportion of stocks held in the portfoliodecreased. At the same time, the volatility decreased, although thevolatility for one month (in Figure 2, row 7) was more than onetwelfth the yearly volatility. The result was that the monthly Sharperatios (in Figure 2, row 10) were lower than the annual Sharpe ratios(in Figure 2, row 5).Comparing monthly Sharpe ratio to Sortino ratio (in Figure 2, row11), the Sortino ratio was always greater, as expected. The basictrend is the same: as more bonds are added to the portfolio thereward/risk ratio goes up. To say it another way, by adding stocks tothe portfolio, one gets more return and even more risk – the riskgoes up faster than the return.This calls to mind a favorite quote: “A ship in a harbour is safe, butthat is not what ships are for.” - John A. SheddAnyway, back to the statistics. The number of trades (In Figure 2,row 12) was never more than the number of funds in the portfoliotimes the number of years because each position came up for annualrebalancing. With small allocations of high-priced tickers, a position
sometimes didn’t change in the rebalancing, resulting in fewer thanthe theoretical maximum number of trades.If you look at the raw trade lists on the companion web site, you’llsee many trades left open at the end of the simulation. That’sbecause each time a few more shares were bought duringrebalancing, a new trade was created. This makes it easier tounderstand what the simulator did and also keeps track of tax lots,which may be useful in the future.As you’ll see later, some other strategies actually traded lessfrequently but they turned over the whole portfolio rather than justtrading a few shares. I’ll touch on the tax implications in a moment.The Average Hold Time is reported in bars or trading days, of whichthere are roughly 250 per year. The numbers listed in the bottomrow of Figure 2 come out to about 7 years, which was far less thanthe test period. What happened was that the few shares boughtduring rebalancing were counted as independent trades and broughtthe average down.The Win Rate (in Figure 2, row 13) was quite high for all theportfolios – over 90%. The 10/90 and 30/70 even reached 100%wins! Every single asset in the portfolio was up from 1998 to 2011,so where did the losses come from? Rebalancing.What If You Didn’t RebalanceSince rebalancing is a bit of a hassle, what if we skipped it? I testedthat out with the 50/50 stock/bond mix. As you can see from therightmost column of Figure 7, not rebalancing cost 0.9% in CAGR,when taxes were not considered. The stats in this case were slightlyworse for just letting the garden grow wild.
Figure 7 – No Rebalancing
Comparison with S&P 500Okay, so I can’t resist a comparison between the diversifiedportfolios and holding only the S&P 500 for the same time period,1998 – 2011. As you can see from the right hand column of Figure2, the S&P 500 produced a 3.6% CAGR, a -55% drawdown, and anannual Sharpe ratio of only 0.14. The returns are smaller, thedrawdown deeper, the reward/risk ratios lower.Clearly putting everything on the S&P 500 was not a big win. Wehave got to find ways to do better! It appears that simply holding /rebalancing a diversified portfolio which includes other funds alongwith the S&P 500 is one strategy. We will look at active strategies,such as ETF Rotation, as well.Report and Commentary on ETF Portfolio from 2005 - 2011Figure 8 shows the simulated results of applying the exact samediversified portfolio strategies to the ETFs (SPY, IWM, EFA, EEM,AGG) over the period 2005 – 2011. In general, the samerelationships hold as for the longer time period with mutual funds soI won’t go through it in detail.
Figure 8 – ETF Portfolio Buy-and-HoldVisit website to download all graphics and trade-by-tradebacktesting dataFor 2005 – 2011, the asset allocation that produced the most returnswith the least drawdown was 40% stocks and 60% bonds with 5.8%CAGR and -23% drawdown. The 30 / 70 portfolio did what lookslike the same CAGR with a drawdown of only -20%. Doubleclicking into the trade-by-trade results spreadsheet shows that 40 /60 did just a smidge better.Mixing in even more bonds reduced the drawdown further butclearly at the expense of the CAGR. Going to the other extremewith 90% stocks and 10% bonds brought the win rate down to 83%with commensurate damage to the CAGR and maximum drawdown.Tax Implications of Portfolio Adjustments
(The following tax assumptions might not apply to you, check withyour tax advisor.)In discussing the number of trades, we noted that rebalancing theportfolio every year required up to one trade per ticker. But thosetrades were often only a small percentage of the account – not acomplete turnover of assets. For taxable accounts (not IRA or401k), you might assume the tax due to rebalancing would benegligible.In fact, I made an estimate of paying 15% tax - the current long-termcapital gains rate for holdings over a year which assumesrebalancing at least 366 days apart. The tax impact of rebalancingon our example was 0.01% CAGR – nothing to get excited about.Gross-Up for After-Tax ComparisonsOne of the advantages of this gentle diversified portfolio might stillbe taxes. To make better comparisons with more active strategies,we can estimate the return required from an active strategy beforetaxes to match the buy-and-hold strategy with a no-tax assumption.In reality, you may still owe taxes just for holding a mutual fundbecause any capital gains taken by the mutual fund will flow throughto you. Even index funds make adjustments such as rebalancing ortracking companies that come and go from the index. This mayresult in taxes even in a buy-and-hold situation – check with yourtax advisor.The top line of Figure 9 shows the return in the ideal case of notaxes. Each row corresponds to a tax rate: 10%, 15%, 25%, 28%,33%, 35%. The intersection of the row and columns estimates whatthe taxable return would have to be to net out to the top line return.
Figure 9 – Tax Gross-UpFor example, if the tax-free portfolio showed returns of 6.8%, then afully taxable strategy that turns over its whole portfolio within a yearwould have to show a return of 9.1% to be equivalent for an investorin a 25% tax bracket.The Reference Portfolio or Baseline for ComparisonThe goal of this chapter was to create a reference portfolio we canuse as a baseline for comparison to more active strategies. Makingseveral backtesting runs added informative insight.Now it’s time to pick a single portfolio to be our reference forcomparison. I focused in on the 50/50 mix because it did the bestfor the longest timeframe. The actual mix of assets is shown inFigure 10.
Figure 10 – Reference Portfolio Asset AllocationBacktesting results are summarized in Figure 11 below. Figure 12shows the year-by-year return of the reference portfolio as well.
Figure 11 – Reference Portfolio Performance Summary
Figure 12 – Year-by-Year Return of Reference PortfolioWith this diversified reference portfolio, we can now move forwardand make meaningful comparisons to more active investmentstrategies.
What Could Be Better Than Diversified Buy-andHoldJust sticking with the diversified portfolio would be great – ifit produced more gain with less drawdown!One common-sense approach to improving performance is totry to shift capital into the top performing assets, riding thegains while staying away from the asset classes which arelanguishing. To make this work, it needs to do two things:
1. Choose asset classes early enough in their run that theystill have room to go up.2. Don’t be so quick to shift asset classes that the portfoliochurns, losing with every whipsaw.The upcoming chapters show you how to do this rotation andhow it would have performed historically. Starting with theassets in the diversified portfolio from last section, it buildsfrom basic rotation to more sophisticated techniques usingstop losses, plus additional asset classes like short funds, cash,long bonds, and commodities.
How to Do an ETF RotationRules for rotation are necessary to make this experiment – andactual trading – objective and repeatable. Early rotationstrategies, especially among sectors of the stock market,attempted to track the current status of the economic andbusiness cycles and shift into areas that should experiencegrowth during the current phase. This is extremely difficult toforecast, even among economic experts. For example,economists don’t officially declare a recession until monthsafter it has begun. By then, the stock market has long sincepriced it in. Also, it is difficult to backtest such judgmentcalls.A simpler, more objective approach is to measure the funds’performance at regular intervals and get into those that rankhighest. As mentioned above, even though we want to alwaysbe in the best funds, it is necessary to give them a littlebreathing room, by allowing a top fund to place anywhere inthe top half before replacing it with a stronger candidate.The Rate of Change (RoC), which is simply the total return inpercentage form, is my preferred metric to select fundsbecause it is easy to understand, quick to calculate, objective,and directly related to performance. A key question, which isanswered in the next section, is: how far back does one go tocalculate the percentage gain for rotation?Basic Rotation RulesBefore we get to the test results, let’s go through the rotationprocess in detail. The rotation rules I currently prefer, whichwere used for this report unless stated otherwise are:
1. Each week, calculate the percentage total return(including dividends) for each fund.2. Rank the funds and note1. The top two2. The cut-off for the top half
3. If the account is 100% cash, split the account 50/50between the top two funds.4. If a currently held ETF is in the top half, hold it.5. If a currently held ETF is not in the top half, then sell it.6. With significant money available to invest (usually fromthe sale in step 5), buy the highest performing fund notalready owned. The new purchase should be one of thetop two ETFs from step 2a. That is,1. If not already in the top ETF, buy it.2. If already in the top ETF, buy the #2 ETF on the list3. If 100% cash, split 50/50 to buy into the top 2 funds.4. Re-balance annually to 50/50 split of the top 2funds.This method stays invested in the top 2 performers, allowingthem to breathe by only selling a fund if it falls into the bottomhalf of the list. When a fund drops to the bottom half, areplacement is picked from the top of the list. It never doublesinto an existing fund but is always invested in two differentfunds.For backtesting, the price data is dividend-adjusted in such away that it appears that dividends were automatically reinvested on the dividend day at the current price with nocommission. That’s not entirely realistic. First off, not allbrokers will allow a commission-free dividend reinvestment.Secondly, it’s possible to hold an ETF through the dividendrecording date, but rotate out before the dividend is paid,resulting in a cash balance in the account. Personally, I justhold dividends in cash until the next rotation opportunity.
Performance of Rotation of Reference PortfolioOne of the key questions from the previous section was how far tolook back to calculate the percentage gain in order to decide whichfunds to pick. Fortunately, computers are fast workers and we canquickly check several reasonable settings.The results of rotating among the mutual funds used for thereference portfolio from 1998 – 2011 are shown in Figure 13. Keepin mind this is a hypothetical simulation – the mutual fund companywould never let you rotate in and out of the funds like this. We areusing mutual funds in the back-test because their history goes backbeyond 1998.The top section in Figure 13 plots the Compound Annual GrowthRates (CAGR) for the rotation strategy in dark gray and buy-andhold of the diversified reference portfolio in black. The lookbacksettings go from 20 to 300 trading days, increasing in increments of10.At a glance, you can see that all settings of the rotation producedhigher returns than holding the reference portfolio. Both the rotationand the reference portfolio have the same assets. The difference isin rotating according to simple rules which historically producedbetter CAGR.The bottom of Figure 13 shows a different story. This is thedrawdown, expressed as negative numbers. In every case but one,this simple rotation strategy - plotted as the light gray line demonstrated more volatility as measured by a deeper drawdownthan the reference portfolio - plotted as the solid black line.The dotted black line at the very bottom is the drawdown of the S&P500, tracked by VFINX. In every case, the rotation strategy wassuperior to passively holding the large-cap index fund.
Figure 13 – Rotation Lookback SettingsVisit website to download all graphics and trade