Category: Relative Strength

Structure update: major asset classes

Approaching month / quarter end, none of the major asset classes are showing any strength relative to cash.

 

 

The only market with any shorter-term upside momentum (see Return B above) are U.S. Long Term Treasuries.  For the bull case, TLT needs to hold above the June low. Failure to do so would turn the trend down.

 

Despite the recent sell-off in U.S. equities, the relative weakness of foreign stocks continues. We have been monitoring this for potential trend change, but there are no signs of that yet.

 

The usual caveats:

  • This is a short example of the type of the analysis we do to assess market structure in order to take tactical positions. We favor diversification at the strategy level and any tactical positions form just a part of the whole.
  • Probabilities play out in the long run, in the short term anything can happen.
  • In no way should any of the above be considered investment advice.

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

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.

 

Backtesting: Combining Relative Strength With A Moving Average Filter

We have added an optional moving average (MA) filter feature to the RS backtest app.  With the recently expanded date start and stop functionality, the applications continue to get more versatile.  

Combining a long-term moving average within the construct of relative strength has been highly requested and we wanted to discuss one idea when considering whether to use it (note that you can just leave it set to ‘off’ as well).  

If you build a relative strength list of say 10 ETFs and you are choosing the top 2,  you could protect your portfolio by including 2 bond funds.   You don’t need a moving average filter because the bond funds will naturally be the ones with the relative strength when equity markets are dropping.   This method actually can get more interesting because you can make better use of more type of ETFs.   Rather than just use cash-like bond funds, you might want to extend the potential holdings to an intermediate bond fund like IEF (7-8 year duration) or others. You don't HAVE to restrict yourself to just stocks and cash.   

Another way to test is by using a moving average.   If you do it this way, then you will inherently be out of ETFs as they go into extended downtrends.  You don’t have to proportionally keep X number of bond funds in your list if you do it this way.    

But a lot of indexes can go above or below a long-term moving average and still not really be a source of market leadership and enhance your return.   Moreover, you may save a lot of money between the time ETFs lose relative strength and the time they actually cross below the moving average.   For these reasons, we believe adding relative strength to a MA strategy will generally be more robust.   Adding MA to a RS strategy is optional -- and you may find works better or worse than your existing method.   Continuous testing leads to better decisions.

 

Research Links on Relative Strength

Some links to published research on various forms of relative strength concepts. The concept is over a century old. (I am not aware of any studies that involve ETFs directly -- let us know if you know of one).

Abstract from paper #1 above 'Time Series Momentum':

"We document significant "time series momentum" in equity index, currency, commodity, and bond futures for each of the 58 liquid instruments we consider. We find persistence in returns for 1 to 12 months that partially reverses over longer horizons, consistent with sentiment theories of initial under-reaction and delayed over-reaction. A diversified portfolio of time series momentum strategies across all asset classes delivers substantial abnormal returns with little exposure to standard asset pricing factors, and performs best during extreme markets.  We show that the returns to time series momentum are closely linked to the trading activities of speculators and hedgers, where speculators appear to profit from it at the expense of hedgers."

Core-Satellite ETF Techniques Introduction

Charles Schwab recently published some summary statistics on their accounts.  They said that while 90% of accounts own individual stocks – just 15% of accounts hold ETFs.  So while many people may have been using ETFs for many years now, using Schwab as a proxy, about 85% of people still need some introduction to ETFs.

There are 3 basics schools of thought on active management in general:

  1. Those that think it’s impossible
  2. Those that think it’s easy
  3. Those that think it’s a challenge -- but rewarding

For those that think passive management is the way to go, your job is still not over.  You will still need to figure out an asset allocation.  “Just buy index funds” actually doesn’t get you far --- there are over 1000 ETFs that follow various indexes and there is no single answer to what exactly constitutes a passive strategy.  I can’t imagine there exists a professionally trained investment advisor who advises putting 100% of money into a S&P 500 index -- but I guess never say never.  So absent that, there are still allocation decisions to be made about stocks vs bonds -- as well as the mix of international stocks and how much to include in alternatives like REITs & Precious Metals.  These are all classic passive indexing discussion points.

For those that think like #2 above – that active management is easy, this crowd is likely just plain dangerous.  They simply ‘don’t know what they don’t know.’      

The third group acknowledges the challenge and comes at the issue with some humility.  We sit firmly in the 3rd camp.  It takes some analysis and testing and hard work to do well in investing.  You don’t need to just come up with ideas – you need an investment PROCESS.  That is, some type of structured approach.  

So let’s introduce the core-satellite approach.  It’s excellent for its flexibility in balancing return & risk.  Here is a visual that Blackrock has used for this:

 

Source:  Blackrock

What makes this framework really powerful is that you can pursue more aggressive strategies --- but still rein in the overall risk of a portfolio.  You can stay within your specific risk tolerance but still buy/overweight some attractive (but perhaps more-volatile) segments.  Or perhaps you are an advisor and your clients have different risk appetites.  You can use your same ideas across these different accounts but just change the allocations between the conservative core and the more aggressive satellite strategies to more precisely target the appropriate risk-budget.

A typical investor thought might be --- I like the idea of investing in Emerging Asia – but how do I do it?  How do I think about the risk involved in the short-run if and when some problem emanates out of South Korea or India or China?

So for a very basic start, let’s mix the core idea of completely passive-indexing with just 1 or 2 actual ideas.  In this example, rather than invest in just the benchmark S&P 500, we will invest 80% in the S&P 500 and 10% in each of two other market segments --- Real Estate Investment Trusts and Gold.

Below is a look from our free Backtest Portfolio app to observe how this portfolio looks Year-To-Date (total return):

 

Note the 3 percentage point pick-up in performance this year for some pretty simple ‘tilts’.   Importantly, note also that there has been some diversification benefit (reduction in volatility).  Other than returns being better, the core-satellite portfolio went down less over the summer.   So it went down less and yet has added 3%.  Your tilts added significant value here.   Not bad for a start.   But we can do better.

If you are a registered user on the site – whether you registered 8 months ago or yesterday – you may have noticed you had 1 starter portfolio we created called ‘Sample Portfolio.’   Rather than use REIT’s and GLD as our satellite strategies, what if we instead used this sample portfolio top relative strength pick as 20% of the portfolio.  Here is that example using our new Advanced RS Application (for subscribers)

 

Notice that the result here is +14.8% return with even more diversification benefit (it went down even less during the summer correction).  Remember, it is 80% S&P 500 in the first place so this is actually an excellent result.  Standalone, this ‘sample portfolio’ that we created in the Spring time has had a banner year --- see for yourself within the portfolio backtest app.  

As you will see when using the TAA application – and as we will discuss in upcoming blogs, you can change the percentage allocations from the core to the satellite and back to the core and see how it affects the overall results -- not just in returns but in ‘smoothing out the ride’ with lower volatility.  This is the very essence of TAA.

All of this is just a start for those who are new to ETFs.  We have many more options available in this core-satellite framework.  A more conservative investor – perhaps older and less willing to take even average risk --- could start with a bond-only core portfolio and then add equities as satellite strategies.  Or we could start with a more diversified core (say mixing REITS & Gold & Junk Bonds in the core) and then add country or sector funds in the satellite(s).   These and other ideas will be future blog topics.

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