SPY-TLT Universal Investment Strategy 20 Year Backtest

Summary

• 20 year strategy backtest using Vanguard VFINX/VUSTX index funds as a proxy for SPY/TLT.
• The strategy uses an adaptive SPY/TLT allocation, depending of the market environment.
• The strategy achieves 2x the return to risk ratio and a 5x smaller max drawdown than a buy and hold S&P 500 investment.

In a previous article "The SPY-TLT Universal Investment Strategy" I presented a simple strategy which allowed to obtain an excellent return to risk ratio only by investing in variable allocations to the SPDR S&P 500 Trust ETF (SPY) and the iShares 20+ Year Treasury Bond ETF (TLT) allocations. The allocation of the SPY/TLT pair is rebalanced monthly using a modified sharpe formula. For the new month, the strategy always uses the allocation ratio which achieved the highest modified sharpe ratio for a given lookback period. Here the algorithm uses a 72 day lookback period and a volatility factor of 2.5 in the modified sharpe formula:

sharpe=72 day return/72 day standard deviation ^ 2.5.

Several readers asked me now to present a longer backtest of this strategy.

Using the Vanguard Five Hundred Index Fund Inv (VFINX) and the Vanguard Long Term Treasury Fund Inv (VUSTX) as a proxy to the SPY/TLT ETFs, here is now a 20 year backtest for the UIS strategy. These index funds are only used to do the 20 year backtest. To run the strategy you would still invest using SPY and TLT. You can also use futures (ES/UB) or leveraged ETFs (Direxion Daily S&P 500 Bull 3X Shares ETF (SPXL)/ Direxion Daily 30-Year Treasury Bull 3x Shares ETF (TMF) or Direxion Daily S&P 500 Bear 3X Shares ETF (SPXS)/ Direxion Daily 30-Year Treasury Bear 3x Shares ETF (TMV)) instead. This is explained in detail in my previous article.

With these two Vanguard funds, this is now one of the rare strategies which can be easily backtested for such a long period. In general however, I think that it is much more important, how a strategy performed after 2008. The market has changed considerably during these last years, and if you would only invest in strategies which can be backtested 20 or more years, then you would have missed most of the investment opportunities of the recent years.

For the backtest, I use our QuantTrader software. This software is written in C# and allows to backtest and optimize investment strategies using this sharp maximizing approach. You see the screenshot of the results below.

The upper chart shows the VFINX/VUSTX performance. The middle chart shows the allocation with red=treasury and yellow=S&P500. If you look at this allocation, then you see that the market is in fact oscillating between "risk on" bull stock markets and "risk off" bear stock markets (= bull treasury market).

Overall, you can say that for buy and hold investors, treasuries have been the better investment for the last 20 years. The sharpe ratio (return to risk) of the VUSTX treasury is 0.79, while the sharpe of the VFINX S&P500 fund is only 0.5. With VFINX/VUSTX combined, the strategy achieves a sharpe of 1.28, which is more than double the return to risk ratio of a stock market investment. This means, that instead of investing 100'000$ in the U.S. stock market, using leverage, you could invest 250'000$ in the UIS strategy. This way you would have the same risk, but you would get 20%-30% annual return.

The strategy shows a very smooth equity line and the real max drawdown is well below 10%. The 11.68% drawdown peak measured in 2008 was in fact only an extreme mean-reversion reaction following a near 20% treasury up spike. The max drawdown is more than 5x smaller than a buy-and-hold stock market investment. Personally I think, this is in fact the biggest argument for such a strategy. All together, we had several major market correction like the 2000 tech bubble dot-com crisis, the 2001 9/11 attack, the 2003 Gulf war, the 2008 subprime crisis, the 2011 European sovereign debt crisis and lots of other smaller corrections. The UIS strategy always performed very well during these corrections.

From 1995 to 2007, the UIS strategy had quite a stable 12% annual return. After 2008, the UIS return increased to 15% annually. The main reason for this improvement is the increased volatility and momentum factors present in the market. After the 55% correction of the U.S. stock market in 2008, VFINX had a lot to recover the last years. In fact, the normal average growth rate of the S&P 500 is about 9% and not 15% like it was during the last 5 years.

The UIS strategy "likes" market corrections from time to time, because then the strategy can profit during the down market from treasuries going up and when the market goes up again, then the strategy can profit a second time from a higher stock market allocation. This way, the strategy can return more than each of the two single ETFs.

If you want to check the monthly investments of this strategy, then you can download here the full backtest Excel file: 20 year performance log UIS VFINX VUSTX

Source: Logical-invest.com

Disclosure: The author is long SPY, TLT. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.