The World Country Top 4 ETF Strategy - A Way To Fight Rising Rates And A Stalling U.S. Stock Market

|
Includes: AFK, ASHR, ECH, EGPT, EIDO, EIRL, EIS, ENZL, EPHE, EPI, EPOL, EPU, EWA, EWC, EWD, EWG, EWH, EWI, EWJ, EWK, EWL, EWM, EWN, EWO, EWP, EWQ, EWS, EWT, EWU, EWW, EWY, EWZ, EZA, FM, FRN, FXI, GAF, GREK, GULF, GXG, IDX, MCHI, MES, NORW, QQQ, RSX, SPY, THD, TLT, TMF, TUR, VNM, VUSTX
by: Frank Grossmann

Summary

The World Country Top 4 strategy is a strong momentum driven strategy creating high returns.

The strategy profits from a maximum global diversification.

With a 20-year CAGR of 20.7%, the strategy has a much lower volatility and lower risk than an S&P 500 investment.

In my last articles, I described various momentum strategies with variable allocations using our maximum Sharpe method. A good example how to build such a strategy is the Universal Investment Strategy, which always invests in a variable allocation of the iShares 20+ Year Treasury Bond ETF (NYSEARCA:TLT) and the SPDR S&P 500 Trust ETF (SPY). However, UIS is a strictly a U.S.-based equity and bond strategy. In the short term, this strategy cannot do much better than its own underlying ETFs, namely SPY and TLT.

Today, many market analysts are less optimistic about the U.S. market. The U.S. stock market may have culminated after 6 very strong years following the 2008 subprime crash. Treasuries, at least in the past 2 months, are underperforming as they begin to anticipate rising yields. It is possible that the UIS strategy underperforms for a few months. Keep in mind that the UIS strategy has been backtested for more than 20 years, and I am quite sure that it will continue to work in the future. However, as with ETFs, every so often, one has to evaluate which strategies outperform and possibly switch some capital to the better performing ones.

We have several new strategies under development (e.g., Countries, NASDAQ 100, Dow 30, U.S. Industries) and we are already investing in these strategies, as to validate them before publication.

To address an underperforming U.S. market, I think the best of these strategies is the Country rotation strategy, which always invests in the top 3 to 4 of 49 countries. One thing is for sure: there are always countries in this selection which are doing well, unless there is a major global crisis. During global crisis, all country equity markets may struggle while money will rush to safe assets like treasuries. Individual country ETFs can easily lose 50% or more of its value if there is a bad government in place. However, after such a period, most of the time, the next government will be more market oriented and the ETF will recover. This political influence of changing governments creates good up and down movements of the country ETFs and these movements are quite independent of the world stock markets. So these country ETFs are well suited for ETF rotation momentum strategies.

If you look at the ETF table at the end of this article, then you will see that there are quite a lot of interesting countries, in which a normal investor would probably never invest without the help of such a strategy.

At the moment the strategy is, for example, invested in:

30% - iShares MSCI Japan ETF (EWJ)
20% - iShares MSCI Switzerland Capped ETF (EWL)
20% - iShares MSCI Singapore ETF (EWS)
30% - iShares MSCI Israel Capped ETF (EIS)

If you read financial papers, you may from time to time, read of these countries. But, by the time you read the positive articles in the press, it is already too late to invest. The country strategy uses a look-back period of 68 trading days. This means that it only needs a little bit more than 3 months to detect if a country is changing from a loser to a winner.

Not all ETFs are single countries. Some represent regions, like for example Africa, the Gulf States or Frontier markets. These ETFs allow you to invest in regions where a single country ETF would be much too small and volatile.

Country ETFs can be quite volatile, so a Top 1 ETF strategy would be much too dangerous. With 50 ETFs, you can invest in quite a lot of top ETFs. For Hedge funds, we would even invest in the top 10 ETFs. For the individual investor, the Top 4 ETF strategy gives the best results. It will smooth out single ETF volatility while simplifying execution and reducing costs. It should be easy and cheap to rotate these 4 ETFs once a month if you have a good discount broker account. Most of the time you will only need to rotate 2 ETFs every month since the strategy may stay invested in the other two for longer periods.

Besides country ETFs, you still need a "safe haven" asset in the case of a market correction. The best safe haven asset is the long-term Treasury bond. Rising rates do not negatively affect the strategy in this case. Once the markets crash, Treasuries quickly become the asset to go to for many investors, and this will remain so even in a raising rate environment.

In our strategy, we use the Direxion Daily 30-Year Treasury Bull 3x Shares ETF (TMF). The 3x leverage of TMF makes sure that we can hedge the volatility of the other country ETFs with a relatively small amount of TMF ETFs. Normally, the strategy will invest in 0-30% TMF Treasury ETFs and 70% or more country ETFs. TMF effectively reduces the volatility and risk of the strategy. The volatility is nearly reduced by a factor of 2, and the strategy is less volatile than a normal S&P 500 investment.

Another advantage of TMF is that you do not have to pay the 30% withholding tax on the dividends like with non-leveraged bond ETFs.

The ranking formula

To calculate the strategy ranking, every country ETF is combined with the TMF treasury. Then the allocation of the two ETFs is changed between 0% and 100%, and for every allocation, I calculate the maximum Sharpe ratio during an optimized look back period (66 days for this strategy). During normal market periods, the maximum Sharpe ratio is not at a 100% stock market ETF or at a 100% Treasury, but somewhere in between.

Here is an example on how the Sharpe ratio changes for the SPY-TLT combination:

The interesting finding is, that the best combination of SPY-TLT gets 5.27, a considerably higher Sharpe ratio than SPY (3.38) or TLT (2.01) alone. This is because the inverse correlation of the two ETFs reduces volatility or risk a lot.

At the time when I made this calculation, this would mean that the optimum composition for the portfolio would be 60% SPY and 40% TLT. This composition is in this case also the one with the lowest volatility.

For the country strategy, I do the same process with all country ETFs combined with the TMF Treasury.

The strategy is using the "Maximum Sharpe" formula, which I have developed for the UIS strategy. This formula allows me to change the character of the strategy between an aggressive performance driven strategy, or a conservative low volatility strategy.

The normal Sharpe ratio is calculated by Sharpe = rd/sd, with rd = mean daily return and sd = standard deviation of daily returns.

I don't use the risk free rate, as I only use the Sharpe ratio to do a ranking. The strategy uses the modified Sharpe formula Sharpe = rd/sd^f with f = volatility factor.

The f factor allows me to change the importance of volatility. If f = 0, then sd^0 = 1 and the ranking algorithm will choose the composition with the highest performance without considering volatility. If f = 1, then I have the normal Sharpe formula and with values of f>1, I rather want to find stock ETF-Treasury combinations with a low volatility. With high f values, the algorithm becomes a "minimum variance" or "minimum volatility" algorithm.

This way I get a ranking of all country ETFs, which is also considering cross correlations to the TMF Treasury ETF. Finally, the strategy uses the top 4 ranked country ETFs.

Backtest description:

20-year backtest

The first backtest was run for the maximum possible duration of 20 years. Only about a third of the ETFs go back to 1996. These include mostly major European countries as well as Japan and Mexico. So, for the first 10 years, the ETF selection is much smaller than today, but nevertheless the backtest shows that such a country rotation worked well during the last 20 years. I have used the Vanguard Long Term Treasury Fund Inv (VUSTX) mutual fund, which is very similar to TLT, to construct a synthetic long-term TMF ETF.

It is interesting to see, that the strategy always kept a high annual performance of about 20% with a volatility lower than the volatility of an S&P 500 investment and considerably lower than an investment in European or Asian stock markets.

20 year statistics

Return

CAGR

Volatility

Drawdown

Sharpe

Top 4 country

3380%

20.8%

16.5%

-36%

1.257

SPY

365%

8.5%

20.1%

-55%

0.423

VUSTX
(TLT proxy)

288%

7.5%

10.8%

-18% (27%)

0.692

10 -ear backtest

The 10-year backtest uses TLT as the safe-haven asset and uses more available country ETFs. The strategy did well during the 2008 crisis. The Sharpe (Return to Risk) ratio of 1.2 is nearly 3x higher than a SPY or TLT investment.

10 year statistics

Return

CAGR

Volatility

Drawdown

Sharpe

Top 4 country

556%

20.7%

16.4%

-36%

1.267

SPY

119%

8.2%

20.4%

-55%

0.401

TLT

85%

6.4%

14.5%

-27%

0.438

5-year backtest

The 5-year backtest has an even higher Sharpe of 1.82, because, since the 2008 crisis, the long-term Treasury correlation to the stock market was mostly negative, which allowed to further reduce volatility.

5 year statistics

Return

CAGR

Volatility

Drawdown

Sharpe

Top 4 country

183%

23.1%

12.7%

-10%

1.821

SPY

119%

17.0%

15.5%

-18%

1.098

TLT

41%

7.2%

15.4%

-20%

0.464

Year-to-date backtest

The last backtest is the year-to-date performance. As you can see, the strategy did quite well with a 12.3% performance, and at this point, it carries no Treasury exposure at all. In other words, presently, it will not be affected by further declining Treasuries due to rising rates.

YTD statistics

Return until May 21

CAGR

Volatility

Drawdown

Sharpe

Top 4 country

12.4%

35.8%

14.3%

-5%

2.511

SPY

4.0%

10.8%

12.4%

-4%

0.872

TLT

-4.9%

-12.4%

16.6%

-14%

Neg.

Table of strategy ETFs

1

AFK

Market Vectors Africa Index ETF

2

ASHR

Deutsche X-trackers Harvest CSI 300 China A-Shares ETF

3

ECH

iShares MSCI Chile Capped ETF

4

EGPT

Market Vectors Egypt Index ETF

5

EIDO

iShares MSCI Indonesia ETF

6

EIRL

iShares MSCI Ireland Capped ETF

7

EIS

iShares MSCI Israel Capped ETF

8

ENZL

iShares MSCI New Zealand Capped ETF

9

EPHE

iShares MSCI Philippines ETF

10

EPI

WisdomTree India Earnings ETF

11

EPOL

iShares MSCI Poland Capped ETF

12

EPU

iShares MSCI All Peru Capped ETF

13

EWA

iShares MSCI Australia ETF

14

EWC

iShares MSCI Canada ETF

15

EWD

iShares MSCI Sweden ETF

16

EWG

iShares MSCI Germany ETF

17

EWH

iShares MSCI Hong Kong Index Fund

18

EWI

iShares MSCI Hong Kong ETF

19

EWJ

iShares MSCI Japan ETF

20

EWK

iShares MSCI Belgium Capped ETF

21

EWL

iShares MSCI Switzerland Capped ETF

22

EWM

iShares MSCI Malaysia ETF

23

EWN

iShares MSCI Netherlands ETF

24

EWO

iShares MSCI Austria Capped ETF

25

EWP

iShares MSCI Spain Capped ETF

26

EWQ

iShares MSCI France ETF

27

EWS

iShares MSCI Singapore ETF

28

EWT

iShares MSCI Taiwan ETF

29

EWU

iShares MSCI United Kingdom ETF

30

EWW

iShares MSCI Mexico Capped ETF

31

EWY

iShares MSCI South Korea Capped ETF

32

EWZ

iShares MSCI Brazil Capped ETF

33

EZA

iShares MSCI South Africa ETF

34

FM

iShares MSCI Frontier 100 Index ETF

35

FRN

Guggenheim Frontier Markets ETF

36

FXI

iShares China Large-Cap ETF

37

GAF

SPDR S&P Emerging Middle East & Africa ETF

38

GULF

WisdomTree Middle East Dividend ETF

39

GREK

Global X FTSE Greece 20 ETF

40

GXG

Global X MSCI Colombia ETF

41

IDX

Market Vectors Indonesia Index ETF

42

MCHI

iShares MSCI China ETF

43

MES

Market Vectors Gulf States Index ETF

44

NORW

Global X MSCI Norway ETF

45

QQQ

PowerShares QQQ Trust ETF

46

RSX

Market Vectors Russia ETF

47

THD

iShares MSCI Thailand Capped ETF

48

TUR

iShares MSCI Turkey ETF

49

VNM

Market Vectors Vietnam ETF

50

TMF

Direxion Daily 30-Year Treasury Bull 3x Shares ETF

Disclosure: The author is long EIS, EWJ, EWS, EWL.

The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it. The author has no business relationship with any company whose stock is mentioned in this article.