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This article is a sequel: the first episode is here (other references: paired switching on SSRN, Seekingalpha).

Paired switching refers to investing alternatively in two negatively correlated assets on the basis on their recent performance, for example using an appropriate momentum indicator. The easiest way to implement a paired switching strategy is to use a T-Bond ETF (for example TLT) and a stock index ETF. The previous article has shown that the best U.S. stock index to play this game during last decade was the S&P Midcap 400 (ETF MDY).

Now I propose to play again with an ETF on emerging countries: EEM.

The concept of "emerging" is very interesting in a paired switching strategy for two reasons:

  1. By definition, what is "emerging" is supposed to have a better trend than a global benchmark. This is an additional bias. However, emerging markets are more volatile. I tried this simulation with the hope to get at least EEM buy-and-hold returns and to avoid the deepest drawdowns.
  2. It is more dynamic than other indexes. EEM's holdings in 5, 10 or 20 years will probably be widely different. New countries and new companies will emerge, and emerging countries may reach the "developed" status.

A question: should we also replace TLT by an emerging sovereign bond ETF (for example PCY or EMB)?

The answer is: absolutely not. The emerging debt may be a valuable asset in a global portfolio, but it is positively correlated with stocks and doesn't suit our goal.

The next table shows simulation results with the following hypotheses:

  • From 5/1/2003 (because of ETF inception dates) to 2/15/2013.
  • The ETF with the highest return last 60 days is chosen.
  • Rebalancing every 4 weeks .
  • 0.1% trading fee.

Definitions:

Total Return: Reinvesting capital, plus gains, minus losses, plus dividends at each decision point.

CAGR: Compound Annual Growth Rate (annualized average return).

DDM: Maximum Drawdown.

Sortino: Sortino Ratio, a risk adjusted performance indicator (higher is better, above 1 is very good).

As it is a monthly strategy, 4 starting dates at least must be tested.

EEM/TLTTotal ReturnCAGRDDMSortino
05/01/03725.0224.04-29.471.13
05/08/03706.9923.81-31.091.19
05/15/03505.0520.26-27.690.98
05/22/03537.4920.95-23.941.02

On the same period, the annualized returns of holding EEM and TLT were respectively 16.23% and 7.15%, with maximum drawdowns of -64.28% and -27%.

The strategy significantly improves the return of just holding EEM and transforms an unacceptable drawdown in a more decent one. The current position is EEM on publication date. You may want to click here for more information about our research.

Source: EEM Paired Switching: More Than 20% A Year Since 2003