I previously detailed here and here how an investor can use ETFReplay.com to screen for best performing ETFs based on momentum and volatility. I select only the top ETFs out of a static basket of 25 ETFs and re-balance the portfolio monthly.
The buy/sell strategy for the portfolio is simple: purchase the top ETFs based on a combination of their 6-month returns, 3-month returns, and 3-month volatility (lower volatility receives a higher ranking) and the average of the 3-month return, 20-day return, and 20-day volatility. I refer to these two different sets as "6/3/3″ and "3/20/20″.
The top 2 ETFs in the 6/3/3 ranking and top 2 in the 3/20/20 ranking are purchased each month. When there are duplicates in the top 2, I look to the third-ranked ETF in the 3/20/20 and, if necessary, the third-ranked ETF in the 6/3/3. The strategy always holds 4 ETFs.
I track this strategy as a public portfolio on Scott's Investments. As of the close April 30th, the hypothetical portfolio was up 13.27% since inception on January 1st 2011. Returns include dividends, but exclude commissions and taxes, and all trades are hypothetical so real results will differ. For some backtests on these strategies please see a recent post here.
For April 30th, the strategy sold its positions in VBR (Vanguard MSCI U.S. Small Cap Value) for a hypothetical gain of 3.94% since its purchase on January 31st. The proceeds were used to purchase PCY (PowerShares Emerging Mkts Bond). The portfolio also continues to hold PFF (iShares S&P US Preferred Stock Index ), SPY (S&P 500 SPDR) and VNQ (Vanguard MSCI U.S. REIT).
Minor fluctuations in rankings may not always justify selling positions each month. For example, if one ETF drops from the second highest rated to the third or fourth highest rated, it may not warrant selling the position. An investor could only sell a position when it drops out of the top 4 or 5 at the end of the month. This type of modification could be used when someone is looking to limit turnover; however, I think it is important to have whatever rule you prefer to use in place prior to making the investment decision in order to avoid discretionary or emotional decision making.
Below is a performance graph of the portfolio (green) versus SPY (SPDR S&P 500 ETF) in purple from the portfolio's inception until April 30th, 2012. Total returns are almost identical but a significant drawdown was avoided: