Backtesting: Combining Relative Strength With A Moving Average Filter
Jan 11, 2011
in Moving Average, Relative Strength
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.
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