ETFReplay Portfolio For January + New System!

by: Scott's Investments

Among the more popular portfolios on Scott’s Investments has been the Portfolio. I previously detailed here and here how an investor can use to screen for best performing ETFs based on momentum and volatility.

The portfolio begins with a static basket of 15 ETFs. These 15 ETFs are ranked by 6 month total returns (weighted 40%), 3 month total returns (weighted 30%), and 3 month price volatility (weighted 30%). The top 4 are purchased at the beginning of each month. When a holding drops out of the top 5 ETFs it will be sold and replaced with the next highest ranked ETF.

In addition, ETFs must be ranked above the cash ETF SHY in order to be included in the portfolio, similar to the absolute momentum strategy I profiled here. This modification could help reduce drawdowns during periods of high volatility and/or negative market conditions (see 2008-2009), but it could also reduce total returns by allocating to cash in lieu of an asset class.

Time to Buy Out of Favor ETFs for 2014?

The top 5 ranked ETFs as of 12/31/13 are below:

HYG iShares iBoxx High-Yield Corp Bond
VTI Vanguard MSCI Total U.S. Stock Market
LQD iShares iBoxx Invest Grade Bond
SHY Barclays Low Duration Treasury

For December the portfolio maintains positions in VTI, HYG and EFA. RWX was sold for a loss of 2.51% and the proceeds used to purchase LQD.

Backtests for this strategy from 2009-2013 are posted below (note that the results do not require an ETF to drop out of the top 5 before being sold – when an ETF dropped out of the top 4 it was sold in the backtest):

(Click to enlarge)

What if we employed a pure momentum strategy on the same basket of ETFs? Purchasing the top 4 ETFs based on 6 month price momentum (no volatility factor), no cash filter, and rebalancing monthly has produced the following results from 2009-2013:

(Click to enlarge)

The momentum only strategy has produced slightly higher returns and slightly higher volatility than the 6/3/3 strategy. This makes sense, since the 6/3/3 strategy incorporates volatility in the ranking system and also requires an ETF to be ranked higher than SHY(cash) before investing. Since cash has little volatility, the 6/3/3 is more likely to invest in cash, leading to lower returns and volatility.

Beginning in 2014 we will track both the 6/3/3 strategy (same system as 2013) as well as the pure momentum system, which will rank the same basket of 15 ETFs based only on 6 month price momentum. There is no cash filter in the pure momentum system, volatility ranking, or requirement to limit turnover – the top 4 ETFs based on price momentum will be purchased each month. The portfolio and rankings will be posted on the same spreadsheet as the 6/3/3 strategy.

The top 4 6 month momentum ETFs:

6 month
VTI Vanguard MSCI Total U.S. Stock Market
EEM iShares MSCI Emerging Markets
RWX SPDR DJ International Real Estate

Disclosure: None