Successful investing is not just about picking the best individual names in a particular asset class. When stocks are booming, even a mediocre company can deliver generous gains. Similarly, when global stock markets are collapsing, chances are that most individual stocks will also suffer heavy losses.
Positioning your portfolio in the best asset classes at the right time can make a huge difference on returns, especially if you are looking to control downside risk during bear markets.
There is plenty of research indicating that investors can outperform a buy and hold strategy in the long term by implementing quantitative trading strategies based on trend following and relative strength.
Trend following basically means that you only invest in a particular asset class when such asset class is in an uptrend. A typical long-term trend measure is the 200 day moving average of prices, so an asset class is considered in an uptrend when prices are above such moving average and viceversa.
Relative strength is about comparing different asset classes. Even if both stocks and bonds are in uptrends, we can compare the two asset classes in terms of their risk-adjusted returns to evaluate which one has superior relative strength.
In plain English, combining trend following and relative strengths means that we are looking to invest only in asset classes that are rising in price over the long term, and we are also looking for the strongest asset classes among the ones that are rising in price.
The Asset Class Rotation System rotates between 9 ETFs that represent some key asset classes.
- SPDR S&P 500 (SPY) for big stocks in the U.S.
- iShares Russell 2000 Index Fund (IWM) for small U.S. stocks
- iShares MSCI EAFE (EFA) for international stocks in developed markets
- iShares MSCI Emerging Markets (EEM) for international stocks in emerging markets.
- PowerShares DB Commodities (DBC) for a basket of commodities
- SPDR Gold Trust (GLD) for gold
- Vanguard MSCI U.S. REIT (VNQ) for REITs
- iShares Barclays Long-Term Treasury (TLT) for long term treasury bonds
- Barclays Low Duration Treasury (SHY) for short term Treasury bonds
In order to be eligible an ETF has to be in an uptrend, meaning that the current market price is above the 10-month moving average. If no ETF is in an uptrend, the system goes for the safest asset in the group, which is Barclays Low Duration Treasury.
Among the ETFs that are in an uptrend, the system buys the top 3 with the highest relative strength. Relative strength is measured by a ranking system that considers total returns over 3 months and 6 months, and it includes volatility as a negative factor.
A 10% increase over 6 months can be a huge bull market for an asset class with low volatility, and it can also be an average gain for a more volatile asset. This means that we need to consider volatility levels when comparing relative strength, so the system is based on volatility-adjusted returns as opposed to standalone return figures.
The ETF portfolio is rebalanced monthly, and the benchmark is a globally diversified portfolio that is allocated 60% to stocks and 40% to fixed income.
Performance numbers are quite strong, over the past decade the system gained a cumulative 325.2% versus 86.3% for the benchmark. Annual return is 14.1% for the system versus 5.8% for the benchmark over that period.
Importantly, the system is much stronger than the benchmark when it comes to reducing downside risk. The maximum drawdown for the benchmark was 35.4% over the backtest period, while the system had a much smaller maximum drawdown of 14.4%.
Considering both risk and return, an investor positioned in the quantitative system would have recovered from the maximum loss in little more than a year, which is far superior to the risk and reward equation that most buy and hold portfolios have produced over time.
The table below shows anual returns and drawdowns for the quantitative system versus the benchmark for every year since 2007.
In 2008, when most asset classes went through massive pains due to the global financial crisis, the system was mainly allocated in low risk assets such as short term bonds, long term bonds, and gold. This is the main reason why the quantitative system does such a great job when it comes to protecting investor capital during times of challenging market conditions.
Importantly, these kinds of systems are not only for investors who trade ETFs based on quantitative indicators. The system can provide enormously valuable information in terms of evaluating the overall market environment and position your portfolio accordingly.
When the system gravitates toward risky assets such as small stocks and emerging market stocks, this is clearly indicating that the market environment is favorable for risky assets, so you can be aggressive on your stocks positioning. Conversely, when the system indicates that it's time for safety by investing in low risk assets, it may be good time to consider the possibility of reducing risk levels in your portfolio.
This ETF rotation system, as well as other quantitative stock-picking systems with outstanding backtested performance are exclusively available to members in my research service: The Data Driven Investor. Until January 31 you can take a free trial and secure a 25% price discount in this link.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.