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ETF Rotation Systems Part 2

|Includes: iShares Core Total U.S. Bond Market ETF (AGG), DBC, GSG, RWX, SPY, TIP, VB, VEU, VNQ, VTI, VWO
Last week I asked when using tactical asset allocation and ETF rotation systems, does the number of ETFs an investor chooses from impact returns? In other words, will rotating between 5 ETFs under-perform a system that rotates among 20?  The answer seems apparent, more options should lead to higher returns.  Last week's test evaluated 3 different portfolios of 5, 10, and 25 ETFs in which the top 1 ETF in each portfolio was purchased in a semi-monthly basis.  I concluded "There was a slight increase in returns as the investment pool increased but the increase was not as large as I had expected."

While much of my interest in tactical asset allocation was initially inspired by Mebane Faber's The Ivy Portfolio: How to Invest Like the Top Endowments and Avoid Bear Markets, this test was done using a different method available for free using  I have written about this method on several occasions on my siteand also track a free portfolio on a monthly basis. The primary difference between the Ivy Portfolio strategy is the etfreplay rotation system purchases the top ETFs based on a combination of returns and volatility and does not require the ETF to be trading above a moving average.

As with last week, this test used a combination of 3 month returns, 20 day returns, and 20 day volatility to rank ETFs. The ETF is not required to be trading above any moving average to be available for purchase. The test purchased the top 3 ETFs and rebalanced semi-monthly (twice per month), which leads to higher turnover although with the introduction of free ETF trades and free equity trades, the added cost of commissions could be minimal. 

The first portfolio examined is Faber's Ivy Portfolio of 5 ETFs with one exception, I used AGG instead of BND because AGG has a longer trading history and the two are highly correlated.  Thus, the first portfolio tested was AGG, DBC, VEU, VNQ, and VTI.  The returns starting in 2007:

Total Changes (trades) 51

Total Return 15.7%
Benchmark (NYSEARCA:SPY) Return -8.1%

Volatility 19.9%
Benchmark Volatility 27.7%

CAGR +3.8%
Benchmark (SPY) CAGR -2.1%

Strategy Drawdown -38.2 %
Benchmark Drawdown -50.9%

Next, I tested the 10 ETF portfolio suggested in Faber's book with again the substitution of AGG for BND.  Eight of the 10 ETFs were trading at the start of 2007, the remaining 2 began trading in mid 2007. The ETFs are AGG, DBC, GSG, RWX, TIP, VB, VEU, VNQ, VTI, and VWO. The results:

Total Changes (trades) 72
Total Return 83.5%
Benchmark (SPY) Return -8.1%
Volatility 18.3%
Benchmark Volatility 27.7%
CAGR +16.9%
Benchmark (SPY) CAGR -2.1%
Strategy Drawdown -22.8%
Benchmark Drawdown -50.9%

Finally, I tested the "broad mix" portfolio I track for free on my site consisting of 25 ETFs.  Of the 25 on the list, only 15 were trading at the start of 2007 which limits the tests to an extent.  The 25 ETFs are BWX, DBA, DBB, DBC, DBV, EEM, EFA, GLD, HYG, IEF, LQD, LSC, PCY, PFF, RWX, SCZ, SHY, SPY, TIP, TLT, VBR, VNQ, WIP, XLE, and XLU.

By the start of 2008 20 of the 25 ETFs were trading.  The results:

Total Changes (trades) 81
Total Return 131.3%
Benchmark (SPY) Return -8.1%
Volatility 15.1%
Benchmark Volatility 27.7%
CAGR +24.1%
Benchmark (SPY) CAGR -2.1%
Strategy Drawdown -8.9%
Benchmark Drawdown -50.9%

Last week I predicted "if the top 3, for example, in each portfolio were purchased semi-monthly we would see a widening of the performance gap between the small (5) ETF portfolio and the large (25) ETF portfolio."   As the returns above show, there was a significant performance gap between the 5 and 25 ETF portfolios, when purchasing the top 3 based on relative strength.

Given the relative short trading histories of many ETFs, it is difficult to draw many conclusions from a small sampling. However, a few things are evident. All three of the ETF portfolios/strategies still clearly outperformed the benchmark, SPY, when purchasing the top 3. However, the 5 ETF portfolio's performance when buying the top 3 suffered significantly when compared to last week's strategy of purchasing the top 1.  When purchasing more than 1 ETF per month, the larger the potential pool of ETFs, the better the returns when using the parameters cited in this article.

Finally, and perhaps most importantly, purchasing the top 3 ETFs out of 25 resulted in almost identical returns to purchasing the top 1 ETF out of 25, but with lower volatility and drawdowns.
For those interested, below is a spreadsheet summarizing returns side by side for the "top 3" strategy:

Ivy 5 Portfolio
Ivy 10 Portfolio
Broad Mix
Benchmark (SPY)
Total Changes (trades) 51   72   81   none
Total Return 15.70%   83.50%   131.30%   -8.10%
Volatility 19.90%   18.30%   15.10%   27.70%
CAGR 3.80%   16.90%   24.10%   -2.10%
Strategy Drawdown -38.20%   -22.80%   -8.90%   -50.90%

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