Seeking Alpha

How To Beat The Market With ETF Rotation Strategies

by: Andres Cardenal, CFA

Investing in the right names in a particular sector is important, but picking the right sectors at the right time can have an even bigger impact on returns.

The Asset Class Rotation Strategy rotates among different kinds of stocks, bonds, and commodities based on trend-following and relative strength.

The strategy has produced attractive risk and return performance over the long term.

Even for investors who don't replicate these strategies, the information provided by the strategy can be remarkably valuable to manage portfolio risk and exposure over time.

As of the time of this writing, the strategy is providing a warning signal for stocks.

Picking the best individual names in an asset class is obviously very important, but investing in the right asset classes at the right time can have an even larger impact on returns. When stocks are booming, even a lousy company can deliver big gains. Conversely, in times when stocks are crashing, most individual stocks will also deliver disappointing returns.

We can never know for sure which asset classes are going to deliver strong returns in the future. However, quantitative research provides the tools to make solid investment decisions supported by hard data as opposed to opinions and speculation.

By analyzing returns and volatility indicators, we can put the probabilities on our side in terms of asset class selection over the long term. Even for investors who don't replicate these kinds of strategies, the information that the strategy provides can be remarkably valuable for decision-making.

The Importance Of Momentum And Relative Strength

Momentum is a pervasive force in financial markets, this means that investments that are delivering superior returns tend to continue delivering superior returns more often than not.

There is no infallible formula to make investment decisions based on this factor, but research has proven that investors can obtain attractive performance over the long term by implementing quantitative strategies based on trend following and relative strength across different asset classes.

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, so an asset class is considered in an uptrend when prices are above the 200-day moving average.

Relative strength is based on comparing different asset classes. Even if both stocks and bonds are in uptrends, we can compare stocks versus bonds in order to evaluate which one is producing superior risk-adjusted returns.

It's one thing to say that commodities are rising, and a very different thing to say that commodities are also outperforming stocks and bonds since superior relative strength speaks volumes about supply and demand dynamics for different asset classes.

Importantly, capital has an opportunity cost. When you invest in an asset class that is underperforming, then you are missing the chance to invest that money in other opportunities with superior returns. You don't just want to buy investments that are doing well on a standalone basis, you really want to buy the ones that are doing better than others.

In simple words, the strategy is based on combining trend following and relative strength in order to invest only in asset classes that are rising in price over the long term and also outperforming other asset classes.

Strategy Design And Performance

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.

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.

Since January of 2007, the Asset Class Rotation strategy has produced a cumulative return of 332% versus 95.6% for the benchmark in the same period. In annual terms, the strategy gained 12.3% per year, more than double the 5.5% produced by the quantitative strategy.

Source ETF Replay

The strategy does a particularly good job in terms of reducing portfolio risk. The maximum drawdown, meaning maximum capital loss from the peak, is 14.4% for the quantitative strategy versus 35.4% for the benchmark in the same period.

Source: ETFreplay

Forward-Looking Implications

Factors such as trend-following and relative strength produce attractive returns over long periods of time, but that doesn't mean that they will necessarily beat the benchmark in each and every year.

When different asset classes are going through major bull and bear markets, the strategy tends to do a great job at capturing those trends. The strategy had a bog exposure to bonds and gold in 2008 and a big allocation to stocks in 2017. In those kinds of environments, a strategy such as this one generally performs very well.

On the other hand, in periods such as 2018, when trends are weak and different asset classes are moving mostly sideways, chances are that the strategy will deliver mediocre returns. Unsurprisingly, a strategy based on momentum works much better when momentum is strong across different asset classes.

Even for investors who don't invest in these kinds of strategies, the strategies can provide remarkably valuable information to make decisions in the market. It makes sense to bet more aggressively on different stocks when stocks are enjoying vigorous momentum and relative strength. Conversely, when stocks are under pressure, investors may want to consider the possibility of reducing exposure to risky stocks.

At the end of July, the strategy was allocated to big US Stocks (SPY), Gold (GLD), and Treasury Bonds (TLT), providing quite a balanced exposure to different asset classes. On the other hand, after the most recent pullback in stocks, the strategy has replaced SPDR S&P 500 with Barclays Low Duration Treasury.

In order to analyze the data visually, we can take a look at the trend quadrants for the 9 asset classes in the Asset Class Rotation strategy. This tool basically compares returns over the past 3 months versus the previous 3-month periods in order to measure how the price behavior is evolving.

It is easy to see how all kinds of stocks of different sizes and in different regions have reversed down recently.

Source: ETFreplay

Source: ETF replay

There is a reason why the strategy is rebalanced on a monthly basis as opposed to daily. Rebalancing too often generates a lot of noise and many false signals, so we still need to give the price action more time in order to tell if the signals will remain in place over the middle term.

Nevertheless, the strategy is currently sending a warning signal for stocks as a global asset class, and this is a relevant piece of information to keep in mind when making investment decisions in the current market environment.

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.