Backtesting a Sector ETF Momentum Strategy

Regular readers know I am a huge fan of cxoadvisory.com, a totally free site which studies various market 'gurus', academic papers, and market strategies. I was browsing the site yesterday and came across the following ETF momentum study by CXO. The study looks at:

a simple six-month past total return momentum trading strategy to the nine sector exchange-traded funds (ETF) defined by the Select Sector Standard & Poor's Depository Receipts (SPDR))...The simple trading strategy starts with $10,000 and each month puts all funds into the one of the above ETFs that has the highest total return over the prior six months.

The ETFs used in the study are the same ones used in my ETF momentum strategy portfolio (although the strategy is slightly different):

• Materials Select Sector SPDR (XLB)
• Energy Select Sector SPDR (XLE)
• Financial Select Sector SPDR (XLF)
• Industrial Select Sector SPDR (XLI)
• Technology Select Sector SPDR (XLK)
• Consumer Staples Select Sector SPDR (XLP)
• Utilities Select Sector SPDR (XLU)
• Health Care Select Sector SPDR (XLV)
• Consumer Discretionary Select SPDR (XLY)

CXO admits the timeframe is extremely short, since the SPDRs have only been trading since 1998. However, the results are encouraging and tend to match other, longer duration momentum studies profiled at CXO. The results are below:

The following chart (click to enlarge) compares the cumulative value of a $10,000 initial investment in this sector ETF momentum trading strategy to that of a $10,000 buy-and-hold investment in SPY. The momentum trading strategy easily outperforms buying and holding SPY. The average monthly return for the momentum strategy is 1.1%, compared to 0.2% for SPY. The standard deviation of monthly returns for the momentum strategy is 5.7%, compared to a less volatile 4.0% for SPY.

What drives the outperformance?

The next chart (click to enlarge) shows the distribution of ETFs selected by the momentum trading strategy over the entire test period. The energy sector comprises 39 of the 107 monthly selections (36%).

What would happen to the momentum strategy if there were no energy sector boom (if we exclude XLE as a choice)?

The final chart (click to enlarge) adds to our comparison the cumulative value of a $10,000 initial investment in XLE and the cumulative value of a $10,000 initial investment in the sector ETF momentum trading strategy excluding XLE as a monthly choice. The average monthly return for XLE is 1.3% with standard deviation 5.8%. The average monthly return for the restricted momentum trading strategy is 0.4% with standard deviation 5.1%. Results suggest that at least boom sector is important to the success of the momentum trading strategy.

Comments

[dewey61:]

Scott, I like your work, keep it up! Do your backtests include transaction fees & taxes in the comparison?

For an individual investor paying $10.99 per trade, and assuming you have a buy and a sell every month except January, that's a 2.5% drag on the $10,000 you start with. So, what is the return vs. buy and hold after factoring this in (plus the affect of the gains & losses)?

Adjusting for taxes is more complicated so it's best to note this analysis assumes trades are done in a non-taxable account.

Dave

Oct 20 11:46 AM

[Scott's Inv...:]

Hi, Thanks - none include tax considerations and most do not include any trade commission assumptions unless otherwise noted. However, this particular test was done by CXOAG and included the following:

"Trading friction is 0.25% of the balance whenever we switch ETFs."

Oct 20 01:04 PM

[Augustus:]

Including something very stable such as BND should help returns. The sector strategy suffered a great deal when required to invest in declining markets.

Oct 21 12:30 AM