This is the third article of a series about Market Timing. In the first one (click here to read) we have seen that the first benefit of market timing is to limit the drawdown and volatility, not to improve the return. In the second part (click here to read), we have seen that a simple management rule sometimes gives a higher return and a lower risk than a complicated one.
Now I will consider a portfolio invested in less correlated asset classes:
- Treasury Bonds
- Worldwide Equities
- Real Estate
Here is a set of seven ETFs I have chosen for this portfolio:
|IEF||iShares Barclays 7-10 Year Treasury Bond||July 2002|
|TLT||iShares Barclays 20+ Year Treasury Bond||July 2002|
|SPY||SPDR S&P 500||Jan 1993|
|IEV||iShares S&P Europe 350 Index||July 2000|
|ILF||iShares S&P Latin America 40 Index||Oct 2001|
|EPP||iShares MSCI Pacific ex-Japan||Oct 2001|
|ICF||iShares Cohen & Steers Realty Majors||Jan 2001|
Because of the inception dates and our data requirements for indicators, the simulations are performed from 6/1/2003 to 1/1/2013.
I want to evaluate this portfolio with two variants of a market timing rule. In both cases we apply the individual timing of my previous article. For each ETF, if the 50-day moving average is strictly above the 200-day moving average, the ETF is in the portfolio, else it is out of it. The portfolio is rebalanced once a week, positions are equal-weight. The variants have the same timing, but a different money management:
1) Every position is limited to 1/7 of the portfolio (14.3%).
2) No limit.
The next table shows the results for a "buy-and-hold" strategy, the two variants of market timing, and the previous article's strategies on the same time interval.
CAGR: Compound average growth return (%).
DDM: Maximum Drawdown (%).
|SPY Buy & Hold||80.59||6.36||-55.42|
|5 indexes Global MT||127.32||8.94||-19.48|
|11 sectors Combined MT||154.17||10.22||-17.34|
|7 classes Buy & Hold||194.95||11.94||-45.82|
|7 classes MT limited||180.09||11.34||-11.38|
|7 classes MT unlimited||272.11||14.69||-17.88|
Even the buy-and-hold version has a better return that the previous strategies, but the drawdown is still high. The market timing with limited position keeps the return in the same range and divides by four the maximum drawdown.
The unlimited version improves the average return at the price of a higher, but acceptable, drawdown.
The following table is a more realistic and detailed comparison of both variants, including leveraged versions. A 0.1% rate is applied for the trading fees and a 2% rate for borrowing the leveraged part.
"Sortino"= Sortino ratio, a Sharpe-like ratio. This is a risk-adjusted performance indicator. The higher, the better.
"Kelly"= Kelly criterion, a money-management indicator that can be used as a probabilistic robustness indicator. The higher, the better.
"Sterling"= Sterling ratio, an indicator of the return strength against the drawdown. The higher, the better.
"DD-MaxDuration"= Maximum duration in drawdown. The lower, the better.
|7 classes MT||Total Return||CAGR||DDM||Sortino||Kelly||Sterling||DD-MaxDuration|
|limited leveraged x2||522.47||21.01||-21.93||0.96||0.19||0.66||91 weeks|
|unlimited leveraged x2||811.32||25.92||-34.5||0.9||0.18||0.58||88 weeks|
Three technical remarks:
- The Kelly criterion is theoretically an invariant by leveraging. But it is not after applying trading fees and borrowing rates.
- There is a higher penalty on the return to leverage the unlimited version. In the limited version, the portfolio is sometimes partly in cash. In this case, the borrowing fees and the beta-slippage are lower.
- The drawdowns of the 2x leveraged strategies are lower than twice the non-leveraged drawdowns, in spite of the borrowing rate. Here, the beta-slippage plays in our favor.
The most aggressive investors might be seduced by the unlimited leveraged version, which has the highest return: over 25% a year. The most conservative ones might prefer the limited non-leveraged version, which has the highest Kelly ratio and the lowest drawdown.
Objectively, the best risk-adjusted performance is the limited leveraged, which has the highest Sortino and Sterling ratios.
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Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.