Introduction to Regime Change ETF Backtesting

Mar 10, 2015

Intro to Regime Change Backtesting

 

Q.  What is regime change?

 

Regime change in financial markets terms means that there is a shift in a basic financial relationship that has governed a backtest periods results.  Some examples might be an inflationary regime changing to a disinflationary era, reflected in how long-term treasury bonds behave.   Or it might be a period of sustained high equity market volatility changing to a more narrow range market.  Or a rising US Dollar vs a US dollar bear market.  Rising price of oil vs declining etc....

 

Q.  Why is understanding what regime you are in important?

 

Models and backtests are good at identifying relationships and how to profit from those relationships.  But standard backtesting is only good if that financial relationship you are backtesting actually stays in-tact.   Relationships develop, exist for a period of time --- often lengthy -- and then they can change.

 

Recall that the rules of financial markets are not like the rules of other areas of observation like in science.   The temperature at which water freezes is the same across time.  However, the financial markets are different and need to be thought about differently.  You cannot be sure that a given financial law will continue into the future.   Water doesn't learn from its freezing in the past and adapt -- but investors do.    

 

Thus, regime change is one of the main problems with many articles you see written that study only very long periods of time.   You get caught thinking something is true over the long-run and so -- since you are a long-term investor after all -- you don't care about a 3-7 year period of poor performance.   

 

But there is a key problem with that,  what if the underlying regime assumption has been mined and through that long-term analysis papers were written about this financial 'law' that exists.   But we know that the thing you are counting on is NOT a law of nature, it is just a financial relationship.   If you are wrong in your belief system,  how much drawdown (or lost performance) will it take you before you figure out your previous thinking was simply flawed in terms of a reasonable time frame of performance analysis (3-7 years)  ?

 

 

Q.  How do you identify regime change?

 

This takes ongoing research.   This takes ongoing thinking.   This takes work.   You can and should think about very long-term backtests too -- we are not advising taking only a short-term approach ---  but then you should also put time and effort into intermediate-term backtesting to help determine whether the model you are relying upon is acting correctly.   Balance the long-term backtests with shorter/intermediate term backtests.  There is no way to know exactly how relationships will hold/change in the future --- but you can monitor them in ongoing fashion.  You don't have to ride a relationship down into oblivion.

 

New ETFreplay Backtesting Module: "Regime Relative Strength" 

 

This new module uses some existing methods that have been on ETFreplay.com for years --- but it now combines them into a single process.   Before, you had to build this using component modules and then assemble and enter the information as an imported backtest.   Now we have automated portions to take more of the monotonous sludgework out and give you more time to do what you should be doing with your time, doing research & thinking about the relationships to test -- not the mechanics of how to make a backtest work and the associated de-bugging.

 

Think of this as a multi-step process rolled into a single backtest.    First,  you come up with a rule of how to define Regime 1 vs Regime 2.   Once the regime is determined,  you line up a backtest strategy for that regime.   When the regime switches, you associate a 2nd strategy for that regime.   You are always in one regime or the other, there is no grey area -- (backtests need to be specific in the details).   

 

We have defined the 'rule' in this case based on the concept of the Ratio Moving Average.   Recall that if you are judging many ETFs (more than 2) against each other,  you should use a multi-factor model.   But if you are just looking at 2 ETFs,  one vs the other,  then you may want to just use the total return ratio of the 2 and define rules that way.   

 

Once you have defined what constitutes Regime 1 or Regime 2,  you can then set up a strategy for each regime.

 

Example: 

 

Regime 1 Rule:  When NASDAQ is beating SHY Over ~100 day lookback  (Absolute Momentum)

Regime 1 Portfolio:   Own the top 2 performing basic NASDAQ Sectors 

 

Regime 2 Rule:   All Other Times

Regime 2 Portfolio:  Reduce drawdown risk but maintain equity exposure by owning lower vol ETFs.

 

This is a very simple example.   You can of course add filters such as cash or moving average filters just like the regular backtesting applications elsewhere on ETFreplay.

 

 

 

 

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What was the S&P 500 Total Return for 2014?

Jan 04, 2015

Total return measures capital appreciation AND the return associated with dividends (and any other distributions -- such as capital gains distributions). It is always surprising how many emails we receive saying our numbers are incorrect because people compare one price to another price. That is INCORRECT. The correct TOTAL RETURN for 2014 for SPY was +13.5%, not 11%. Total return in 2014 was +2.3% higher than the price return. (There is no actual such thing as a 'price-only S&P' -- the S&P index price only exists as an index, NOT as an investable fund -- nobody would be so stupid as to buy a fund that doesn't pay out its earned dividends). For ETF's with higher yields -- (and/or for those with cap gains distributions) -- this difference will obviously be higher.

Over a few years, this difference really adds up to be a VERY substantial amount.

 

 

 

 

 

 

 

Click for link to free Total Return vs Price Return Page

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Using Different Weightings Based On Rank In an ETF Relative Strength Backtest

Dec 11, 2014

 

User Question:

I run a portfolio relative strength backtest with 5 ETF but all are assigned an equal weight of 20%. How can I assign different weights to the ranked ETFs? Example: Top 5 Weighted as 30%, 30%, 20%, 10%, 10% respectively."

Answer:

For this you would use the Advanced Relative Strength Backtest Module (subscriber link).

By layering the strategies using different numbers of selections while at the same time using the same ETF list, you can create weightings based on Rank.

Note that the top ranked security in this portfolio list would receive 10% from portfolio 1, 10% from portfolio 2 and 10% from portfolio 3. The backtest report combines weights and it becomes simply 30% for the top ranked ETF. The backtest will appropriately rotate the 30% weight to the top ranked security and likewise for the other ETFs. Dive into the backtest report to see all the breakdown of sub-periods and the weightings of each ETF and its contribution to return for that period.

 

 

 

 

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Updated Robo Adviser 13F Performance

Nov 02, 2014

 

One of the more entertaining things we've read about is how Robo advisers have some type of special algorithm for asset allocation.   This is nonsense.   As you can see from the chart below, using the 13F SEC filed holdings of a major Robo Adviser,  the return path is essentially identical to another popular allocation fund in our database.    These funds all are using the same basic asset allocation --- the line about having a special algorithm is just for marketing purposes.

Note that the Robo 13F portfolio has not included the adviser fees -- but does include the underlying fund fees.   Subtract the adviser fee from the 13F return to get the adjusted figure.

 

 

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Robo Advisor Performance Using 13F Holdings

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Welcome to Mutual Funds: Janus Unconstrained Bond Class A vs Class C Shares

Sep 29, 2014

 

We wonder how many investors possibly understand this extremely simple concept.   ETFs do NOT HAVE SHARE CLASSES.   Mutual funds have share classes for one reason -- to make more fees for the fund company and brokers.

Below is image highlighting the tradeoff in 2 classes of Janus Unconstrained Bond Fund.    Bill Gross the manager just manages one large sum and probably doesn't even look to see which share class has the assets --- it doesn't matter to him, he just buys and sells bonds for the aggregate portfolio.   But for investors,  the fund is divided into segments.

In this case,  you could go with Class A shares which have a 4.75% sales front load fee and an expense ratio of 1.08%.    Or you could buy Class C shares and pay no front load --- but pay a 1.83% expense ratio  and owe 1.00% as a back load --- when you sell it you are stuck an extra 1%.

Now think about it from a brokers perspective.   Which do you want your clients to buy?   If you have incentives to push load funds,  perhaps you stick your clients with the A shares because your firm gets that juicy 4.75% upfront fee.     However,  note the 12b1 fees.   Class A has a 0.25% 12b1  and Class C has a 1.00% 12b1 fee.    What is a 12b1 fee?   It's an ongoing kickback from the fund company to any outside broker who puts their clients in that fund.   So for example,  you are a broker that works for a company that is not Janus --- Janus will pay you an ongoing fee forever to keep your clients in it.    That fee is IN ADDITION TO whatever management fee you charge your clients.   The great part about 12b1's is that they are hidden! 

Do ETFs have 12b1 fees?   Nope.     So doesn't that make you wonder, why would a broker ever put a client in an ETF when they can earn 1.00% forever from Janus?  The problem with those silly ETFs is that how do you make any money off them?     Exactly.     This is the very essence of the problem.     Yet ETF assets continue to grow and grow and grow.  How is that?   Because many investment advisors are content with simply charging a straightforward fee and do the right thing and don't buy fees with loads and 12b1's.     Fees like 12b1 fees have been totally outlawed in other countries as too much of a conflict of interest.   But not in the USA.   

That all said,  Janus C shares might be a RELATIVE bargain compared to many hedge funds.    Happy investing.

 

 

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CFA Curriculum Type of Blog Post: Reward vs Risk

Jul 02, 2014

When you study finance, you have to first learn the basic fundamentals of portfolio theory. When you eventually move to real life, you quickly realize how theory is only a starting point. Nevertheless, it is useful to know the "book theory" because it provides something of a very basic framework. That said, in the words of the great investor Mike Tyson "Everyone has a plan 'till they get punched in the mouth." First, here is the look of a list of ETFs that climb up the risk curve.

 

 

Note that this was posted on this given date covering this very specific time period. Using those precise assumptions, the book theory held up nearly perfectly -- a line going from lower left to upper right --- more return for more risk. But you have to remember --- that was using some very careful selections. Here is an example of a different time period where equity investors were punched in the mouth, Tyson-style:

 

The point is that the volatile ETFs that are towards the right side of the chart will be the ones to have large intermediate-term drawdowns and large intermediate-term returns.     The ETFs on the left side will have low drawdowns and low returns.     These are very generic ETFs.    Where this gets much more interesting is when you use other ETFs that track more interesting indices.

 

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Financials Sector Earnings Per Share

Jul 01, 2014

 

A look at Financial Sector Earnings. 

 

 

 

 

Understand the ETFreplay Backtesting Layout Here:

ETFreplay Backtesting Layout Video

 

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Country Funds vs Their Moving Averages

Jun 21, 2014 in Regions

It was interesting to read bearish stories in March and April given that the Global Market was at that very moment IMPROVING.    While U.S. has been in an unbroken bull market,  you can see how there may be better opportunities for new leadership elsewhere....

 

 

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ETFreplay Top 100 Trillion Dollar Real-Money Portfolio Update

Jan 12, 2014 in ETF Multi-Asset 100

ETF investors in the top 100 exchange-traded products made +$136 billion in 2013.  Actually, they made more than that if you count inflows -- but we calculate the ETFreplay 100 by locking in starting assets as this captures the big themes quite well.

We began the ETFreplay 100 project a year ago to try to show a proxy for how investors are ACTUALLY doing.   The fact of the matter is that most people with wealth do not hold just 1 type of investment -- they own a portfolio and that portfolio consists of more than just US Stocks and Bonds.   There is no universally accepted benchmark -- nor should there be --  your individual benchmark is dependent on various factors that differ:  ie,  your age, your risk tolerance, your liquidity needs, your time-horizon etc...

So investors in reality own an allocation of different assets that hopefully corresponds to their profile.   What we do with the ETF 100 is aggregate all those by using ETF asset levels and then monitoring that total return performance over time.    The $136 billion in profits equates to a +12.7% total return for the year.

Learning to ignore all the noise on financial TV and twitter about INDIVIDUAL investments and instead focusing in your own process is extremely important.  Differentiate between what 'sounds good' as a one-liner on TV or a blog vs what actually matters -- your PORTFOLIO total return.    In the end, the only question that actually matters is --- did you make progress against your financial goals?

The ETFreplay 100 covers well OVER $1 trillion in assets.   US Stocks were the star performers in 2013.   Below summarizes the results and the most significant contributors and detractors for the year:


For a side comparison,  we compare the results to the most watched hedge fund benchmark:

 

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