-by-tradebacktesting dataIn practice, we need to select just one setting for the lookbackperiod. We need that for live trading, and to make the rest of thebook manageable. To guard against over-optimization, pick asetting that is among a plateau of good settings rather than anisolated peak.Choosing 140 trading days (between six and seven calendar months)as the lookback period to calculate the percentage gain appears tomeet that criterion. Many charting packages will calculate this as a140-bar RoC – the difficulty is in getting them to operate on totalreturn data. You can download an open source spreadsheet thatmakes this calculation from my site at truthaboutetfrotation.com.140-day RoC Rotation ResultsA detailed comparison to the reference portfolio of the 140-dayrotation for mutual funds and for ETFs is shown in Figure 14. Asabove, the CAGR is better but the drawdown is worse for rotation.The Sharpe ratio is a single metric that balances both the risk and
reward. In Figure 14 you can see that the rotation strategiesproduced a better Sharpe ratio than buy-and-hold.
Figure 14 – Simulated Rotation PerformanceVisit website to download all graphics and trade-by-tradebacktesting dataThe number of trades for the rotation strategy was roughly threetimes that of buy-and-hold. The win rate dropped considerably, andthe size of the wins decreased as well. The rotation strategy lost agreater percentage of the time. Overall, however, the rotationstrategy accumulated more gains, as evidenced by the higher CAGR.The average number of bars held at the bottom of Figure 14 showsthat the rotation strategies stuck with one fund for an average of lessthan 60 trading days. This is about 12 weeks or one calendarquarter. We can expect the full portfolio to turn over within a yearand so should assume all gains would be taxed at the short term rate,if held in a taxable account.If held in an IRA and traded with limit orders at a broker that offersa commission-free arrangement, the turnover doesn’t necessarily addto overhead.Tax Considerations
One of the oft-cited benefits of buy-and-hold is tax considerations.Referring back to the “gross-up” table in Figure 10, to come outahead a mutual fund rotation strategy would need to produce gainsof 9.1% for a middle (25%) tax bracket and 10.5% for the topfederal (36%) tax bracket. The 140-day rotation came in at 11.6% tostay ahead after taxes. For the ETF portfolios over 2005 – 2011,buy-and-hold produced 5.8% CAGR and rotation got 9.3% CAGRbefore taxes. 5.8% grosses up to 8.8% at a high federal tax rate sothe rotation just squeaked by, and in fact may not be viable for ataxpayer in the top bracket with state tax to contend with besides.For most tax brackets, however, I think this shows that running arotation strategy in an after-tax account is not out of the question.Of course, your personal situation may be different, consult your taxadvisor.Year-by-Year ReturnsYear-by-year total returns are reported in Figure 15. Comparingback to Figure 12 for the reference portfolio gives insight into howrotation produced higher gains with greater volatility.
Figure 15 – Year-by-Year Performance of Basic Rotation StrategyIn two of the four down years, the rotation did considerably worse.In 2000, the buy-and-hold portfolio only gave up 1% overall whilethe rotation lost 12%. Again in 2002, buy-and-hold gave up 3.6%
compared to 10.5% loss for rotation. Neither did well in 2008, withcomparable losses of 18.2% for mutual funds and 16.6% for ETFs.Finally, in 2011 both methods showed small losses.In the profitable years rotation made up for any losses. Only in 2004and 2010 did sitting on the diversified portfolio make more moneythan the rotation. Rotating the mutual funds often showed more thantwice the gains, however, the strategy is too active to carry out onmutual funds. With the ETFs, the superiority is less pronounced butstill very evident. In 2005 -2007, the rotation blasted out roughly19% per year while buy-and-hold spent two of those years withsingle digit gains.2009 produced curious results: 42% versus 24% with mutual funds,28% versus 19% with ETFs for rotation versus buy-and-holdrespectively. First of all, why the differences between mutual fundsand ETFs? Largely it is because the funds do not always track thesame indices with the same representative instruments, even thoughthey may follow the same asset class. Also, they have different feestructures but that is a smaller impact.Checking the trade-by-trade data for 2009 illustrates the differences.Between buying shares in 3/26/09 and selling a few shares torebalance on 01/04/10, VEIEX gained 70% while EEM was only up64%. The majority of the emerging market shares bought on3/26/09 were sold on 2/25/10 for a gain of 56% for VEIEX or on2/10/10 for a gain of 50% on EEM. In just this one trade, there wasa 6% difference in performance between VEIEX and EEM!This example also illustrates the value of rebalancing becauseroughly 15% in profits dissipated between the annual rebalancingexit and the rotation to another fund. Experiments with morefrequent rebalancing are reported in a later chapter (Does ActiveRebalancing Help Grab Profits?).Overall, the backtesting tended to validate the rotation strategy overbuy-and-hold for all but the most tax-sensitive traders.
What If You Don’t Own a Home?Investors who don’t own a home, or who want more exposure to thereal estate asset class, may be curious to see what happens with therotation strategy when a real estate fund is added.To produce Figure 16, the same rules were applied to the same fundsas Figure 13, except that FRESX was added to the mix. FRESX is aFidelity mutual fund that focuses on real estate companies, bothdomestic to the United States and international. It was chosenbecause it is one of the few pure real estate funds dating back to the1990s. In recent years, FRESX performance was generally higherthan IYR, an ETF that tracks a real estate index.
Figure 16 – Rotation Performance by Lookback Period with RealEstateAs before, the dark gray line in Figure 16 shows the CAGR of therotation strategy for various settings. The light gray line plots thedrawdown. Compare to the solid black lines for the performance ofthe reference portfolio. The dashed line is the S&P 500 drawdown.
The general results are about the same with real estate as without:the rotation strategy produced higher returns but with worsedrawdown. With real estate, it appears that the sweet spot for thelookback period grows to 160 days.
Which Day of the Week to Rotate?Most of the runs for this book rotated the ETFs on Thursday, usingthe closing price on Thursday. What happened if a different day ofthe week was adopted? Not much difference, according to Figure17.
Figure 17 – Day of the Week ComparisonWednesday came out on top with a 13.9% CAGR. Monday was thelaggard at 12.6% CAGR, confirming its reputation as a hard day.Thursday placed second with 13.7% CAGR.No surprises in these results. That they were clustered togethersuggests this is a robust strategy. A wide variation would be a redflag. However, it is extremely unlikely that all days of the weekwould produce exactly the same statistics. One of the days has tocome out on top and it happened to be Wednesday in thisexperiment.I don’t know of a good reason why Wednesday should stay on top,yet after seeing Figure 17, I’m making my rotation trades based onthe closing price on Wednesday.Since the closing prices and ranking are not necessarily known intime to place a real trade, I enter limit orders to execute on Thursday,pegged to the closing prices on Wednesday. This also serves tocontain slippage. If my limit order is not filled by the end of the dayThursday, I will change it to a market order to be sure the tradehappens.
Bring on the Long BondsOur basic list of ETFs to rotate consists of four stock funds and onebond fund. With this mix, it is never possible to get entirely out ofthe stock market during a downdraft.Adding another bond fund changes that by giving two safe havensfrom the stock market. We’ll later look at rotating to cash. For now,funds that track the long US Treasury bonds will serve. Toimplement this from the historical perspective the VUSTX mutualfund from Vanguard was included in the back-test. For more recentperspective and live trading the ETF from iShares, TLT, is thechoice.Figure 18 shows the results of applying the same rotation rules to themutual funds (VFINX, NAESX, VEIEX, VGTSX, VBMFX,VUSTX) during 1998 – 2011. Then the ETFs (SPY, IWM, EEM,EFA, AGG, TLT) were backtested during 2005 – 2011. One moretime period, 2009 – 2011, was added in order to see how the strategyworked lately.
Figure 18 – Rotation with Long Bonds
In head-to-head comparison, we can see thatincluding the long bond funds, VUSTX or TLT,added value early on by boosting CAGR from11.6% to 13.5% and reducing drawdowns from-35% to -20.9% for the mutual funds during1998 – 2011. Even more impressive: with theETFs from 2005 – 2011 the CAGR jumped from
9.3% to 15.8% while the drawdown droppedfrom -34% to -21%.From 2009 – 2011, when the stock marketlargely went up, occasionally rotating into TLTslightly increased CAGR from 9.7% to 10.1%and allowed a max drawdown of -15.1%compared to -16%.
Shorting the Market with Inverse FundsThe next series of comparisons takes place between 2007 and 2011because that’s when index fund ETFs became available to trackcommodities and short funds. (Yes, inverse mutual funds wereavailable sooner but the overhead of tracking many different timeperiods was getting too much.) The second and third columns ofFigure 19 are reruns in the 2007 – 2011 time period to give pointsfor comparison.As you can see comparing the third and fourth columns of Figure19 TLT does better than inverse fund SH as a fifth wheel in therotation strategy. TLT in column 3 produced a 13.2% CAGR withalmost -15% max drawdown.SH moved a couple percentage points in the wrong direction with11.2% CAGR and -17.7% max drawdown. Including both SH andTLT brought the CAGR up slightly to 14.2% with a slight worseningof max drawdown to -16.8%. Note that the basic ETF rotationperformance came in at 5.4% CAGR with -34% drawdown duringthis very tough time period.Adding both TLT and SH improved the situation during the 2008credit crisis.
Figure 19 – Including an Inverse Fund to Short the Market
How About Those Commodities?Commodities have the potential for gain. Unfortunately, theybring volatility with them. Column 6 in Figure 19 above,shows that adding commodity index fund DBC to the basicETF mix during 2007 – 2011 improved CAGR to 9% —above the basic ETFs but below SH and/or TLT. The maxdrawdown hit new lows at -41% though.
Everything But the Kitchen SinkBringing a full complement of ETFs - SPY, IWM, EEM, EFA, AGG,TLT, SH, DBC – boosted the CAGR to 15.5% while widening themax drawdown to -21.8%. See the rightmost column in Figure 19.Clearly, tinkering with the list of ETFs produced gains with slightincreases in volatility.Comparing back to buy-and-hold of a diversified portfolio continuedto show the benefits of rotation. In this case, Figure 20 showsbacktests for 2007 – 2011 where the reference portfolio of 50%stock index funds and 50% AGG bond fund brought in only 3.8%CAGR with a whopping -30% max drawdown.
Figure 20 – Buy-and-Hold Reference Portfolio 2007-2011Splitting the bond allocation between AGG’s broad spectrum andTLT’s focus on 20-year treasuries helped somewhat by creating aCAGR of 5.8% with a -27% drawdown. Making room forcommodities was not worth the effort as the CAGR came in at 4%with a -38% max drawdown.
Rotating to Cash when Everything RotsThe previous sections demonstrated the benefits of being able tocompletely take money out of the stock market on occasion.Allocating assets to bond funds or even short funds both increasedthe returns and decreased the maximum drawdown.However, bond funds, especially long bonds such as 20-yeartreasury bonds in TLT, can be volatile themselves. The price of along-term bond is sensitive to interest rates and other factors. It isnot risk free. “Risk-free Treasuries” refers to short-term TreasuryBills which do not fluctuate much during their brief lifespan.Inverse funds are not only volatile; they come with higher built-inexpenses. Worse, an inverse fund is not designed to track the marketfor long periods; they only try to offset the daily behavior of theunderlying index.What if we simply hold assets in cash when the funds are notperforming well? When the percentage gain over the last 140trading days falls below zero, it says the fund has lost money on anintermediate-term basis. We can take that as a signal to move tocash.The revised rules for rotation, including a safe haven in cash, are:
1. Each week, calculate the percentage total return (includingdividends) for each fund.2. Rank the funds and note1. The top two2. The cut-off for the top half3. Which funds have positive gains over the past 140-days3. If the account is 100% cash, split the account 50/50 betweenthe top two funds which have positive performance over thepast 140-days. If no funds have positive performance, just stayin cash.4. If a currently held ETF is in the top half with positive gains,hold it.5. If a currently held ETF is not in the top half, or is not showingpositive gains, then sell it.6. With money available to invest (usually from the sale in step 5),buy the highest performing fund not already owned with
positive gains. The new purchase should be one of the top twoETFs from step 2a. That is:1. If not already in the top ETF and the top ETF had positivegains, buy it.2. If already in the top ETF, buy the #2 ETF on the list, if ithad positive gains.3. If 100% cash, split 50/50 to buy into the top 2 funds withpositive gains.4. Re-balance annually to 50/50 split of the top 2 funds withpositive gains.Doing the full-scale backtest resulted in the statistics in Figure 21.The second and third columns show the results of rotating amongmutual funds and cash for the period 1998 – 2011.Relying on only the basic funds (VFINX, NAESX, VEIEX,VGTSX, VBMFX) with cash added did better but with higherdrawdown than including long bonds via VUSTX.To see where using cash as an asset improved the results, comparethe basic+cash run with CAGR of 11% and max drawdown of -28%with the original rotation in Figure 14 which produced a similarCAGR of 11% but much worse drawdown of -35%.However, Figure 18 showed 13.5% CAGR and -20.9% maxdrawdown for rotation among basic mutual funds and the long bondfund VUSTX. That turned out to be a better performance thanincluding both cash and long bonds as shown in Figure 21, column2.
Figure 21 – Cash as an Asset in RotationUsing ETFs for the period 2005 – 2011 again showed that addingcash to the menu of choices reduced the max drawdown from -34%to -22.8% and at the same time the CAGR crept up from 9.3%. to10.8%. However, from Figure 18 we saw that rotation among theBasic ETFs + TLT produced a CAGR of 15.8% with -21%drawdown.
During 2007 – 2011 the results with and without cash are about thesame, suggesting that some of the funds always gained during thattime. This period included the 2008 credit crisis in which TLTsoared while the stock market crashed.So we must conclude that rotating to cash did not always get the bestor safest performance. Selecting the right mix of funds producedbetter results. In a later chapter which double-checks the asset mixover a longer time period, the benefits of cash rotation were evenless clear. Cash rotation also brings additional steps in a slightlymore complicated set of rules for rotation.However, cash rotation limited the drawdowns without making anegative impact on returns with the basic set of funds. It isworthwhile to include cash as an asset class in the rotation becausewe have no guarantee that the same funds will outperform in thefuture. In the next crash, it may not be TLT that represents safehaven and then cash might be a welcome respite from the markets.
What Happened with Stop LossesAttempting to shave the drawdowns with stop losses was not veryeffective. See Figure 22 for data. All runs used the basic set ofmutual funds with cash as an asset class, over the timeframe 1998 –2011. The stop loss was set at a fixed percentage below the entryprice and triggered a sale if the stop price was hit while the fund washeld.
Figure 22 – Rotation with Stop Losses and Cash as an AssetIn general, the performance suffered. The CAGR went down andyet the drawdown got worse. This illustrated the effects of thrashingbetween funds as they take short-term pullbacks. At 10% and even15% stop losses the gains were pinched without any improvement inthe drawdown.Stop losses of 20% and 25% produced exactly the same results asthe unconstrained runs with cash as an asset class. This means thestops were never hit when placed 20% below the buy price.Rotating weekly is designed to give each asset enough room tobreathe yet cut off losers before they plummet too far. It appearsthat works better than setting stop losses – at least when cash wasconsidered one of the asset classes.When cash was not one of the asset classes, stop losses served toreduce the drawdown as illustrated in Figure 23. Stopping out aftera loss of 10% from the entry price and then picking another fundsqueezed out slightly better CAGR and drawdown compared withcash rotation.However, stop losses in particular get idealized treatment inhistorical simulations. My brokers have advised me that my realstop loss orders in the market may not be honored if the marketdrops quickly. If they are filled, it may be at a much lower price asthe market could plunge mid-day but recover by the close. In
summary, going to cash may be easier and safer than counting on astop loss to avert disaster.
Figure 23 – Stop Losses without Cash as an Asset
Does Active Rebalancing Help GrabProfits?One last attempt to grab more gains involves rebalancing morefrequently to try to catch a fund while it is up and rotate a portion ofthe profits into the next one that might advance. Figure 24 tells usthat monthly rebalancing offered no reward for the extra work whileweekly rebalancing was counter-productive.
Figure 24 – Rotation with Frequent Rebalancing
Double-Checking the Asset MixIn later years, the inverse fund SH helped contain the drawdownsand even add profit while the stock market fell. Just to be sure usinginverse funds is a good idea – because it is notoriously difficult tomake money on the short side of the market — I did one more set ofbacktesting runs shown in Figure 25.
Figure 25 – Long-term Backtest with an Inverse FundAgain, including Treasuries with VUSTX and an inverse fund,RYURX, squeezed out 2% more CAGR with a little less drawdown.Definitely this mix won during 1998 – 2011.Curiously, the longer term results with stocks, bonds, long treasuries,inverse funds, and cash as assets came in slightly behind the simplerrotation without cash but all the same funds as assets. Allowing arotation into cash when the funds are down intuitively feels safer andallows the investor to stand aside if all other asset classes are gettingwhacked.
Which Strategies Beat the CrashAlmost every rotation strategy produced more profits than buy-andhold of the reference portfolio, although sometimes those profitscame at the expense of greater drawdowns.Adding an inverse fund and a 20-year Treasury bond fund did themost to beef up gains while pruning drawdowns. Rotating to cashoffered downside protection without much performance hit. Stoplosses did not improve on a weekly rotation with cash as an asset.Neither did rebalancing frequently.To summarize, the ultimate strategy of the bunch tested in this bookrelied on these funds:
SPY or IVV for S&P 500 stocksIWM for Russell 2000 small-cap stocksEEM for Emerging Market stocksEFA for International Developed Market stocksAGG for Barclay’s composite bond indexTLT for 20-year Treasury bondsSH for inverse S&P 500…traded in a weekly rotation among the top two funds, according tothese rules:
1. Each week, calculate the percentage total return (includingdividends) for each fund.2. Rank the funds and note1. The top two2. The cut-off for the top half3. Which funds have positive gains over the past 140-days3. If the account is 100% cash, split the account 50/50 betweenthe top two funds which have positive performance over thepast 140-days. If no funds have positive performance, just stayin cash.4. If a currently held ETF is in the top half with positive gains,hold it.5. If a currently held ETF is not in the top half, or is not showingpositive gains, then sell it.
6. With money available to invest (usually from the sale in step 5),buy the highest performing fund not already owned withpositive gains. The new purchase should be one of the top twoETFs from step 2a. That is:1. If not already in the top ETF and the top ETF had positivegains, buy it.2. If already in the top ETF, buy the #2 ETF on the list, if ithad positive gains.3. If 100% cash, split 50/50 to buy into the top 2 funds withpositive gains.4. Re-balance annually to 50/50 split of the top 2 funds withpositive gains.…which produced the following results in hypothetical historicalsimulation:13% CAGR with -22% maximum drawdown when backtested onmutual funds during 1998 – 2011 and 13.9% CAGR with -16.7%maximum drawdown when backtested on ETFs during 2007 –2011. See Figure 26.
Figure 26 – Hypothetical Performance of the Ultimate ETF RotationStrategyOver the longer term, each fund was held, on average, roughly 100trading days, which is about 5 calendar months. Thus we canassume all trades get taxed at the short term rate. At 13% CAGR,
this strategy may still come out ahead for current federal taxbrackets compared to buy-and-hold of the reference portfolio.In a tax-free environment such as an IRA or these backtests, therotation results were far ahead of buy-and-hold.Figure 27 shows the year-by-year backtested performance of thisultimate rotation strategy. The detail of buy-and-hold returns for thediversified reference portfolio is repeated right alongside.The mutual fund backtest results go back to 1998 while the ETFrecord begins at 2007. Both run to the end of 2011. The differencesin results between the mutual funds and ETFs are due to the differentfund compositions. Overall, rotation demonstrated substantial gainsinterspersed with smaller losses and compared favorably to buy-andhold of a diversified portfolio.
Figure 27 – Ultimate Rotation Strategy Compared to HoldingReference PortfolioThe equity curves plotted in Figure 28 illustrate how a hypotheticalaccount starting with $10,000 might have fared under rotation (the
dark gray line) or buy-and-hold (the black curve).
Figure 28 – Equity Curves from Backtesting Ultimate Strategy vs.Buy-and-HoldRotation won out big-time in the end, but notice that the first fiveyears were a toss-up where buy-and-hold was often ahead. In 2006and 2010, the holding the reference portfolio produced lessvolatility. Keep in mind that the reference portfolio was diversifiedacross several asset classes and makes a strong investment in itself.From 2004 – 2009, the rotation strategy actually doubled its equity.Zooming in on the credit crisis of 2008, you can see the rotationaccount growing while the diversified portfolio dropped offdramatically.Of course, future results will vary. Before investing with anystrategy, you should carefully consider your resources and goals aswell as the risk of loss.The next step from here is to forward-test this strategy, which I amdoing with live trading in my own retirement account. You can trackprogress at http://truthaboutetfrotation.com/forward-testing/.
ResourcesWeb SitesFor bonus materials including
all tables from this bookan ETF Rotation calculator for Exceltrade-by-trade backtest dataclick here to visit the special page for owners of this book.truthaboutetfrotation.com - the book’s companion websitebeathecrash.com – website for this whole series of booksdivergence-alerts.com – members can follow along with myETF rotation strategy and also get a list of the MACDdivergences on US stocks, ETFs, and futures.backtestingblog.com – backgroundbacktesting, including glossary
information
on
Coming soon! More Beat the Crash ™ e-books on Kindle…Videos On Amazon.comBeat The Crash - Diversified Portfolio Baseline, Vol 1 Disc1
This educational session lays thefoundation for the Beat The Crashseries by defining a baseline forcomparison of investment strategies.A diversified portfolio is described aswell as its hypothetical historicalperformance.Also covered are
metrics for comparing investmentstrategies.Beat The Crash - Truth About ETF Rotation, Vol 1 Disc 2Delves into how to do ETF Rotation and the historicalsimulated performance of rotating the diversified portfoliointroduced in Disc 1.SoftwareRotation Spreadsheet - an open-source spreadsheet that canhelp you find the top ETFs by calculating the 140-day totalpercentage gains. It also computes stop losses and attempts tosize each trade. Available at this book’s companion website:truthaboutetfrotation.com.Related ReadingMycurrentreadinglistishttp://backtestingblog.com/order/books/ .
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AcknowledgementsThank you to John Chernicky for his insightful reviews of thisbook. All errors are mine.Scott Ajax spotted errors in the original drawdowncalculations in my portfolio testing software. I am thankfulthat he persisted in calling them to my attention until theywere fixed. I take responsibility for all remaining bugs andmiscalculations.I am grateful to Aric Egmont at Fidelity Investments formotivating me to give sector rotation a second look, and forpublishing my article on the topic.Thank you to my family and friends for patient understandingand encouragement while I research the market and write.Hat tip to Pearl Sofaer for publishing her book which inspiredme to write mine.Thank you, Dear Reader, for your attention. The knowledgethat you will be reading this book motivated me to put in mybest effort.
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