Decreasing Volatility In An ETF Rotational Strategy

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 |  Includes: DBC, EFA, GLD, IEF, TLT, VTI, VWO
by: Dennis Lastor

The goal of any rotational strategy is to seek out alpha by selecting those assets which are poised to outperform the market or other stylized benchmarks.

Tactical Asset Allocation (TAA) is an active portfolio management strategy which allocates funds to a number of asset classes, and periodically rebalances between those asset classes based on market metrics such as momentum, strength, seasonality, or other strength-based market factors.

While this approach can perform well when compared to the broad based indexes, its strength lies in both the underlying asset classes chosen as well as the methodology for quantifying market strength, or momentum. One approach to smooth an equity curve when deciding on your asset classes is to diversify.

As an example, choosing uncorrelated asset classes both decreases your overall exposure and reduces drawdowns in weak markets. Although many correlations approach '1' in a market shock, diversifying into asset classes that contain a mix of Commodities, U.S. broad based indices, Foreign Markets, Real Estate, and Bonds provides some level of protection even in market shocks. For example, an asset basket consisting of DBC, EFA, IEF, GLD, TLT, VTI, and VWO is just one of many diversified example portfolios.

Not only is this basket diverse and relatively uncorrelated to one another, but including IEF, TLT, and GLD allows these three assets to be chosen, or rotated into weak markets and market shocks, further decreasing volatility in your equity curve. To illustrate, we look at the 1, 2, and 3 year performance of a basket of assets consisting of DBC, EFA, VNQ, XLF, SPY,VTI, and VWO. In this back test, we rotate into the two 'strongest' ETFs based on weekly relative strength:

1Yr

-5%

2Yr

0.8%

3Yr

5%

Inception

(since 2005)

8%

Annualized

Sharpe Ratio

1.52

Click to enlarge

2 ETF Max Drawdown

-7.6%

S&P 500 Max Drawdown

-59%

Click to enlarge

Adding IEF, TLT, and GLD back to the basket, and removing VNQ, XLF, and SPY, we see a pronounced improvement in performance:

1Yr

20.5%

2Yr

17%

3Yr

17%

Inception

(since 2005)

15%

Annualized

Sharpe Ratio

3.82

Click to enlarge

2 ETF Max Drawdown:

-1.15%

S&P 500 Max Drawdown:

-59%

Click to enlarge

These figures do not account for slippage or commissions.

How do you determine the strongest, or best of breed ETF within your basket to rotate into? This is open to interpretation, experimentation and governed largely by your own trading style. One possibility is relative strength, where returns are taken and ranked on each asset class. From this ranked list of assets, rotating into the strongest one, two, or three assets may fit your trading style and risk appetite. One methodology that I've recently adopted is to take a short-term ranked order of returns, a medium-term ranked order of returns, and a medium-term rolling volatility and compute a 'score' based on these metrics.

For example, I might give a 50% weighting to the 15-day ranked return, a 30% weighting to the 20-day ranked return and a 20% weighting to the 20-period volatility. Next I could compute an overall score based on the sum of the two weighted returns, minus the weighted volatility. Ranking this score from highest to lowest provides me a list of relative strength, ranked banked assets to rotate into on a weekly rotational strategy. Including a volatility component further decreases the `score` and prevents highly volatile underlyings from ranking near the top of the list.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.