Truth About ETF Rotation - Fund - Patterson, Jackie Ann

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Beat The Crash Volume 1



Truth About ETF Rotation -

Fund Your Retirement

by Investing in Top Exchange Traded Funds

in One Hour Per Week



By Jackie Ann Patterson



©2012-2013 Own Mountain TradingCompany

All rights reserved. No portion of thiwork may be reproduced in any mannewhatsoever without written permissio

except for brief quotations in criticareviews.

Published by:Own Mountain Trading Company dbBackTesting ReportP.O. Box 620427



Woodside, CA [email protected]+1 650 752 4921

www.ownmountain.com www.backtestingreport.com

Despite best efforts to produce a usefuand correct report, this book may contaierrors. Much of the data relies obacktesting, which is a historicasimulation with significant differencefrom real live investing and trading. Nclaim is being made that you will mak

money from this book, and in fact yomay lose money from investing. Thauthor is not a licensed financiaplanner. You must consider carefull

http://www.backtestingreport.com/

http://www.ownmountain.com/

mailto:[email protected]



what is right for you and consuprofessionals as needed.

This book is intended for educationapurposes and is not a recommendation tbuy or sell securities.

HYPOTHETICAL OR SIMULATEDPERFORMANCE RESULTS HAVE

CERTAIN LIMITATIONS. UNLIKE ANACTUAL PERFORMANCE RECORDSIMULATED RESULTS DO NOT

REPRESENT ACTUAL TRADINGALSO, SINCE THE TRADES HAVEOT BEEN EXECUTED, THE

RESULTS MAY HAVE UNDER-OR

OVER COMPENSATED FOR THE



MPACT, IF ANY, OF CERTAINMARKET FACTORS, SUCH AS LACKOF LIQUIDITY. SIMULATED

TRADING PROGRAMS IN GENERALARE ALSO SUBJECT TO THE FACTTHAT THEY ARE DESIGNED WITHTHE BENEFIT OF HINDSIGHT. NOREPRESENTATION IS BEING MADETHAT ANY ACCOUNT WILL OR ILIKELY TO ACHIEVE PROFIT OR

LOSSES SIMILAR TO THOSESHOWN.





Table Of Contents

Dedication

Introduction My Story

How to CompareInvestment Strategies

How Index-MakersRule

How to Create a



Diversified Portfolio

Performance of Buy

and-Hold o

Diversified Portfolios

What Could Be

Better Than

Diversified Buy-andHold

How To Do An ETFRotation

Performance o



Rotation of Reference

Portfolio

What If You Don'

Own a Home?

Which Day of the

Week to Rotate?

Bring on the LongBonds

Shorting the Markewith Index Funds

How About Those



Commodities?

Everything but the

Kitchen Sink

Rotating to Cash

When Everything

Rots

What HappenedWith Stop Losses?

Does ActiveRebalancing Help

Grab Profits?



Double-Checking

the Asset Mix

Which Strategies

Beat the Crash

Resources

Acknowledgements



Dedication

For my mother who set anexample of kindness and

generosity.



Introduction

You can retire in comfort and securityYour investments can provide for youiving expenses and free you to live th

good life. It is not that hard, but it wilrequire you to master a few techniqueo monitor the markets, keep your min

alert, and maintain the persona

discipline to act decisively on occasionEven if your life savings was devastateby the last decade, this book can givou the tools to help re-build it and ge

our retirement back on track.

As I write this, the world economy ha



been on life-support for years. Stimuluprograms are a regular and familiacrutch. Interest rates wallow at all-tim

ows. The real estate market took umble and loans are not so readil

available to fund a cash-flow empirbased on rental property. Looking bacover the last decade in the stock marketwe’ve experienced tremendous gainand harrowing downdrafts. The onl

group that has done exceedingly well ibond investors, and that may well bescalating into the next big bubble.

Are the days gone when individuals likou and I could hope to suppor

ourselves without depleting an account’



principal in the process? Admittedly, iooks bleak. But what if you could sens

when to approach the stock marke

aggressively and when to shift to a morconservative stance?

This is exactly what large monemanagers are doing with what they cal“risk-on / risk-off” strategies. The ides that when they perceive conditions ar

favorable to taking risk, they jump in thmarket full-force. As conditions shift take on a dangerous tone, the risk-of

orders go out, and the markets drop ahe money takes flight to safety.

The trouble is that these money manager



don’t alert us, the general public, to theirisk assessments. Instead they quietlpull out, selling the assets they believ

are on the brink of disaster to an unwarpublic. After all, someone needs to holhe bag.

f you’d rather not be one of theistooges who buys at the top of the markeonly to learn about the big playergetting out or even selling short, then th

eat the CrashTM series of books is foou. My goal is to lay out a set of dat

and indicators that you can reference tmake your own call on when and how tparticipate in the market. Use the tooldescribed in the pages that follow t



help understand when it’s a prime timo be in the market, and when a mor

conservative asset allocation is mor

ikely to be rewarded.

The indicators and techniques chosen fo

he Beat the Crash series run the gamufrom fundamental to technical tsentiment. Their common attributes are:

Robust track record

Apply to the broad market o

economy as a whole

Objective



Relatively simple

This first book in the Beat The Cras

series serves two purposes. As the titl“Truth About ETF Rotation” suggests

he main idea is to show you how to puogether a strategy that rotates among top

Exchange Traded Funds (ETFs).

Before diving into ETF Rotation, thifirst book in the Beat the Crash seriedefines the standards we will use t

evaluate whether an indicator or methocan help us understand the market. Iestablishes a baseline for comparison –

a reference point to see how well th



strategies are working. To do that, wwill look at simple ways to manage diversified portfolio and decide wher

o invest funds when the game is on.

Clearly, I’m not advocating a buy-and

hold strategy, nor is it high-frequencrading either. Buy-and-hold leaves u

vulnerable to large losses that take yearo recover. In practice, it’s a rarndividual who actually carries out buy

and-hold. Instead, many people who seout to buy-and-hold lose their resolv

after a market plunge, only to finhey’ve sold at, or near, the bottom. Orhey make my friend’s favorite mistake

buy a promising stock and hold throug



stellar gains, but end up selling for small loss once it comes back to earth.

Just because we’re not married to stock or market outlook does not meahat we need to spend our days an

dollars trading in and out frequentlyThat style of trading presents manchallenges, both technical anpsychological. It is increasingldominated by automated high-frequencrading taking place in computer center

co-located with the stock exchanges.

ndividuals have limited resources tcompete in the high frequency tradin

game. Besides, I have no inclination t



spend my retirement years staring at computer screen! I’d wholeheartedlrecommend that you balance your lif

beyond the markets as well. Remembermoney management is a means to an endnot the end to itself.

f your end goal is indeed a betteretirement, you may find you do better tpractice these strategies in a retiremenaccount. A self-directed IRA at discount broker will do just fine. If youfunds are stuck in a 401k with limite

choices, you may have to adapt somstrategies to the mutual funds provideand consider the 401k’s restrictions orading carefully before each move.



f, instead, you are investing in a regulabrokerage account, you may be liable foaxes when moving money between asse

classes. But even paying taxes is bettehan all-out losing your savings!

These strategies are meant to protecour nest egg as much as grow it. The

attempt to point out promising times trisk money in the stock market and takdefensive action when the going getough. No doubt we will sometime

experience losses using the tools set ou

n the Beat the Crash series of booksWe have only the assurance that we’vdone our best to learn from history rathehan blindly repeat it.



The companion website for the Beat th

Crash series of books ibeathecrash.com. For this book i

particular, you’ll find the companion sitat truthaboutetfrotation.com. Follow thinks within this e-book to access figure

and detailed backtesting data.

http://www.truthaboutetfrotation.com/

http://www.beathecrash.com/



My Story

Let me tell you my story. I am not natural born investor or trader. Rarelgraced with the intuition to do the righhing at the right time, almost everythin

learned came through one of twways: a series of hard knocks oexhaustive computer simulations. Eve

once I saw that money could be made ihe stock market, I stumbled forward ihe dark until certain events forced me t

shed a little light on what I was doing

My purpose in writing this book is thelp illuminate your path to greatesuccess in the markets.



The truth is that I didn’t set out to forge career backtesting the stock market. Ifact, I didn’t even set out to trade th

market. I am a computer engineer braining. What with stock options aniving in Silicon Valley for the tec

bubble in the late 1990’s I couldn’t helbut notice that money came from thstock market.

started out very conservative, figurinhat I had very little so I better not lost. I selected the most conservativ

choice for my 401k funds. Some socalled Guaranteed Fund, somethinabout investment-grade insurance blahblah-blah -- I didn’t look that closely bu



“Guaranteed” sounded good.

Ha! The Executive Life insurancndustry debacle taught me that even th

most conservative-sounding choices cablow up. It is important to understan

what really underlies the marketinnames. All was not lost thoughEventually money trickled out of thbankruptcy settlement. A few years ag

received a back payment from thGuaranteed Fund. Nice, but it’s mucess useful to be made whole 20 year

ater!

Working at a software company as th

nternet took off, I traded just for kicks



t seemed all my colleagues had theiown little formula. The Altera rep tCisco bought more stock in bot

companies each time he received a salebonus, which was often. A marketinmanager bought shares of whateveelectronic company would try out hieading edge design product and h

profited. I tried my hand at findindot.com initial placements (IPOs) an

flipping them as they caught on fire.

But I didn’t make as much as I could

Being anxious that dot.com mania waoo good to be true, I tried to make

more conservative allocation of fundsThat’s how I came to have my accoun



balance once again slashed by holding bond fund in a rising interest ratenvironment. I got around to fixing tha

ust before the tech wreck induced flight to safety of treasury bonds. I waet to see that the choice of conservativ

versus aggressive allocation had more tdo with the market state than my agerisk tolerance, and goals.

Like most adult Americans, I knowexactly what I was doing on Septembe11, 2001. On a business trip to Boston,

had a little time in my room before mfirst meeting and was selling stock omy laptop. I’m not kidding, I was tryino place a sell order and NASDAQ wa



not responding. The room servicwaiter told me a plane had hit the WTCMy sell order was lost among th

unfolding drama on television and mweek-long adventure traveling homafter Boston’s Logan airport closed.

When the markets re-opened severadays later, I opened the brokeragwindow on my laptop once again. Noselling but buying. Not because I knewanything about bottoms or volatility osentiment extremes but because I though

t patriotic to support the market witwhatever I could muster.

Meanwhile, after more than a doze



ears in industry the work felt likdrudgery punctuated by corporatbattles. I started to take financia

ndependence more seriously. I’earned early on not to trust financia

advisors. I’ve lost enough being “pun” funds– thank you. I hate being “pun” funds. I decided to make time t

seriously learn to manage my owmoney.

When I sold my house in Saratoga, CA iate 2002, I had more ready cash, an

hought, “Now I can really give trading whirl!” With what now, in hindsighseems like amazingly little research, plunked the proceeds of the sale into



couple stocks. Right there in the office, ust casually put my life savings on thine and went off to a meeting.

Right. I was quietly freaking out. Bacn my office glued to my screen,

watched as every little tick of the stocprices drove my account balance wildWhen it was up, visions of private jetflew before my eyes. When it wadown, my whole insides just shrivelen fear – I couldn’t even see straight.

Sometimes fear is the appropriatemotion. That was just too big, toreckless and I am too anxious to b

doing that. I liquidated to cash, ran ou



of my office, and went for a blazinwalk around the park thinking, “I’m surglad I don’t have to do THAT for

iving!”

So back I came to “make a difference” i

he corporate world with renewevigor. My career enthusiasm didn’t lasong. Surviving something scary can b

exhilarating and soon I was back lookinfor more exciting market adventuresBesides I wasn’t so sure my currenmiddle management position was reall

making much difference in the worlanyway. On top of that my father hapassed and I needed more time to helmy elderly mother who came to live nea



me.

So I took classes, read dozens of booksand put together a trading plan thapromised to set me free. I worked at iuntil I had a quarter where my profit

matched my “day job”. Then I set out omy own.

Ah the good life! I rafted the GranCanyon, snorkeled Hawaii, took rading class in Cyprus, another i

Florida, and a third in Arizona. Everday, my laptop came out and I managemy trades before going back to my fun. competed in the Spike Group tradin

contest, earning two silver medals fo



quarterly performance and growinconfident.

Things started to change – gradually afirst. Gradually as in that scene from thmovie Jaws where the lady is treadin

water and first experiences a surprisinittle tug on her leg. Okay, that’s to

dramatic. You can see where I geanxious.

Really what happened is more subtle

While traveling in Europe, trading thUS market is an after-dinner activityOne night, I got on the wrong side of rade and couldn’t let it go

Unfortunately, I stubbornly tried to tel



he market what to do -- an expensivantrum.

ext day, I thought it prudent to eat ittle extra from the breakfast buffet an

enjoy a light, inexpensive dinner. B

Portugal, I was packing away boileeggs from the breakfast buffet becaushat was going to be dinner as my tradinosses grew.

o job and losing money in the market

How frightening is that?

’d like to think I have other prospects

But I hear a younger woman sits in m



office now. My secret fantasy workinat REI with all the cool outdoor productdoesn’t include sore feet an

embarrassment of waiting on my formecolleagues. Anyway, the credit crisiand subsequent retail contraction toocare of that.

o choice but to make money from thmarkets! Except that’s way too mucpressure to trade. With more computeskills than market savvy, I decided tsell my backtesting research to fund m

ongoing studies of the market. Now offer reports, videos, software and aalerts service to the public. Also, I dconsulting on strategies for trading an



nvestment.

The really great thing about starting thibusiness turns out NOT to be the moneyFirst off, it rekindled my love ocomputers, software and even custome

support. But the best thing is really thamazing things I’ve learned from mclients.

One of my biggest clients, Fidelitnvestments, asked me to write an articl

on sector rotation1

. I saw the potentiaof trading a rotation strategy but needeo work out a few issues raised in th

article.

https://www.fidelity.com/viewpoints/buy-and-hold-sector-rotation



Well, “working out a few issuesamounted to developing my owportfolio simulation software, acquirin

historical data, running endless tests -basically starting over from scratch tresearch ETF rotation in the context odiversified portfolio management. Thibook is the summary of my newresearch.

One other important comment: I’m not registered investment advisor. Thquantitative results and discussion in thi

report are meant for educationapurposes only – not specific investmenadvice. You are in charge odetermining what fits your needs an



emperament. All trading and investmencomes with risk of loss and is not foeveryone.



How to Compare Investmen

Strategies

This section discusses metrics tcompare investment and tradin

strategies. Yes, it is dry, but the readinwill make it easier to understand thnuances of the backtesting performancof the various strategies presented late

n the Beat The Crash series of booksYou may want to skip to the next chapte

How Index-Makers Rule) if you ar



already familiar with mathematiconcepts or simply uninterested idelving deeply into investment retur

measurements.

Everything Is Relative

s 6% per year a good return? Idepends on your perspective.

To investors looking to meet specifipersonal goals, such as providing for thkids’ college or paying the monthly billn retirement, the absolute return may b

all that counts. If it meets the need, fine

f not, keep looking.



Relative returns, on the other hand, maka comparison to a benchmark becauseverything’s relative. In a good year,

6% return may seem quiet beside throar of the market. In a crash howevert’s a smug investor who comes ou

ahead by 6%.

hat is the Golden Standard fo

Comparison?

The investment world tends to compar

returns to one of two different standards

The first is the risk-free return, typicall

assumed to be the interest paid by short



erm US Treasury bills. This is ofteused in the risk / reward computationsuch as Sharpe Ratio, which is how it

used in this book.

Another tactic is to compare returns t

he most relevant benchmark. Foexample, a stock mutual fund compareo the Standards and Poor's S&P 500®

and a bond mutual fund compares to bond index.

The trouble is that both of these goldestandards have been off their game in thast decade. Interest rates droppehrough the floor, tempting conservativ

nvestors to take more risk to ge



anything back on their money. Sinc2000, the secular bear market shreddehe previously glowing stock marke

returns.

A Better Baseline

When deciding on an investmenstrategy, it’s better to make relativ

comparisons between different strategieover the same time period. Howeverust comparing to non-existent interes

rates or an erratic bear market is toeasy.

A better baseline is one that produce



decent returns and is also easy toperate. For the Beat The Crash serieof books, a diversified portfolio o

assets represented by mutual funds oExchange Traded Funds (ETFs) wilform the baseline. More on that in thupcoming chapter, How to Create Diversified Portfolio.

hat Metrics to Compare?

Having decided on a baseline fo

comparison, next comes the choice owhat attributes of each investmenstrategy to compare. Read on for aoverview of the metrics that will b

reported for the baseline diversifie



portfolio and for each investmenstrategy in the Beat The Crash series obooks.

Price Gains alone do not includdividend / interest payments so they d

not present the whole picture evehough they are relatively easy to com

by. Typically, only price gains ar

presented in other publications. That inaccurate and gives stocks an apparenadvantage over bonds and othedividend-paying instruments.

Total Return is the price of the assetplus its dividend payments. Dividend

do matter, especially when dealing wit



bond funds. This is also the money thaends up in your account! Beat Th

Crash will rely on total return

ncluding dividends for both backtestinand reporting.

Returns may be expressed in severadifferent ways, each with its owadvantages and disadvantages.

Year-by-Year Return gives a feel fohow the strategy performed. It exposehe trade-offs between strategies tha

may have similar average returns anvarying volatilities. For example, this iwhere you can most simply see thdifference between a strategy that plod



along earning about the same per yeaversus a wild ride that wins big, losebig and averages out about the same. I

s hard to compare lots of strategieear-by-year so this level of detail wil

only be presented in select situations.

Compound Annual Growth Rat

(CAGR) is comparable to interes

rates. Applying CAGR each year takeou from the initial account balance the ending balance albeit more smoothlhan the real ride. Geometric Mean i

he general concept behind CAGR. Thgeometric mean is the metric of choicfor academics interested in the OptimaGrowth Strategy. Intuitively, it make



sense to make this as large as possibleWho doesn’t want a fast growinportfolio, if all else is equal?

Average Return is easy to calculate ahe arithmetic mean each period’s return

but simply taking a starting accounbalance and applying the average retureach year won’t give the ending balancike CAGR. Keep in mind that a loss o

50% requires 100% gain to recoup!

Average return is also the mathematica

expectancy, if the sample size is largeThe arithmetic mean, along wit

variance, is the metric used by ModerPortfolio Theory, which forms the basi



of your financial advisors’ mandate tdivide assets between stocks and bondaccording to your age and ris

preferences

Excess Return Over “Risk-Free

Return shows how the strategy dicompared to keeping the money in thsafest known investment vehicle. Th

risk-free rate has varied considerablover the test period for these financiastrategies. Many computations boidown the risk-free rate to one number t

represent the whole test period. Insteaduse the actual rate of 3-month U

Treasuries available on each day durinhe test period. I don’t care if my stoc



holdings beat the average of risk-frerates, but I want to know if the stocstrategies beat the risk-free rate offere

at that time. This is especially importanat the present time when the 3-month ratapproaches zero but was up over 8% i1990.

Risk Metrics

magining the upside of investmenstrategies is great fun but anyone wh

has ever put money in the stock markeknows that it’s not all beauty and graceAs prudent investors, we need ways testimate how much the various strategie

expose us to risk and how well the



reward us for bearing risks.

Drawdown measures equity drops fropeak to trough without regard to monthlor annual boundaries. It takes the higpoint of an account balance and subtract

he low point to tell you how much wenmissing during a market downturn. Oncagain, we will rely on total return

because dividends can soften the blowof drawdowns.

While drawdown is relatively easy tvisualize, it is harder to plug into thprobabilistic functions that allow us tcompare risk-adjusted returns acros

different horizons and anticipate wha



else might go wrong based on what hahistorically gone wrong.

Volatility expressed as the standar

deviation of returns is often adopted aa measure of risk because it is a way t

quantify the possibility of nastsurprises. Computing the standardeviation allows the math geeks amon

us to use probability theory tools testimate the likelihood of returns withia range.

Beware that the stock market does nofollow all the assumptions that go withe usual probability estimates such as

normal distribution. Historically, th



stock market has misbehaved much moroften than would be expected accordino probability theory. It is said tha

market returns exhibit “fat tails” becaushe occurrence of the unlikely hasn

dropped to nothing as quickly as thmath might indicate.

Since most of us don’t think in terms o

probability distributions, the SharpRatio is useful as a single metric thaquantifies risk and return. It is defineas the average returns above

benchmark divided by the volatility ostandard deviation of the returns abovhe benchmark. It can be calculated o

either a monthly or annual basis.



A key decision when calculating thSharpe ratio is what to use for thbenchmark return. For simplicity, an

since the annual returns are a broabrushstroke, a single number of 2.8% iused. That is the average annualized 3month Treasury rate for the period o1990 – 2011. When calculating thmonthly Sharpe ratio, however, we’rgetting down into the gritty details an

hen the actual month-by-month 3-montTreasury rate is used.

Unfortunately, most documents anprospectuses do not disclose thbenchmark used for the calculation of thSharpe ratio. Also the Sharpe ratio wil



vary depending on the time perioapplied. For those reasons, it’s actualldangerous to compare Sharpe ratio

across various publications. Within theat the Crash series of books, you ca

be assured that the Sharpe raticalculations are applied consistently anhus useful for evaluating the relativ

performance of the investment strategieested.

As typically calculated, the professionameasures of risk-adjusted performanc

carry us away from the notion thadrawdown is the bad guy. Anythinbased on standard deviation as measure of volatility penalizes us fo



upside gains as well as downside lossewhich may seem harsh. The commonsense explanation is that if somethin

went up abruptly in good times it has thpotential to go down sharply when thingurn sour. Also, preference is given tstrategies with more consistent returnrather than a few big winners because consistently growing account balancmakes financial planning easier.

Many other risk metrics exist. Foexample, the Sortino ratio is ver

similar to the Sharpe ratio except that does not penalize for good returnbecause is based on the semi-varianceTo calculate it, only the negativ



variance from the risk-free return wacalculated. The Sortino ratio generallcomes out with a larger number than th

Sharpe ratio.

The Beat the Crash series of books wil

primarily report maximum percentagdrawdowns, standard deviation, anSharpe ratio to answer the key questionDid hopping in and out of the markeactually improve the risk-adjusteperformance for investors?

Other Interesting Statistics

Other statistics can be of interest whe



mulling over strategies. Highlights are

Number of trades per year

Average holding time of each trad

Win rate (% of times selling for

profit)

Timeframes

Repeatedly, I’ve said that you can onlcompare certain metrics within the samime period. So what timeframes are w

considering for these experiments i



nvestment management?

The limiting factor is getting good datfor the backtesting. US Treasury interesrate data back to 1990 is at oufingertips on the web. However, most o

he interesting ETFs weren’t availabluntil 2005. Mutual funds pre-dateETFs, however, passively managemutual funds that follow market indicedid not come into vogue until th1990’s. Yes, Vanguard came out with fund that mirrored the S&P 500 in th

ate 1980’s but it wasn’t until 1997 thaan interesting selection of index fundfor foreign and domestic markets camout. On top of that, we need about



ear’s data to look back upon whemaking the first investment decisions iour strategies.

After careful consideration of all thfactors, the simulation for this repor

will focus primarily on the followinime periods:

2005 – 2011 for recent ETF

performance

1998 – 2011 the largest perio

with enough funds to make ETFrotation interesting



Strategy Simulation via BackTesting

Backtesting measures the relativperformance of a set of investmenstrategies by simulating the strategies ohistorical price data. Backtesting can b

done by hand but is usually automated bcomputer software these days. The rulefor buying and selling are objectivel

defined and programmed into thbacktesting engine which proceeds daby day through the price data anrecords the results from all the trades.

Since backtesting relies on past data, makes no guarantees about upcomin

performance and can’t say whether



strategy will do as well in the future as did in the past. However, if a strategdidn’t perform in the past, there’s n

reason to believe it will suddenly turnto a winner. It pays to avoid strategie

with a losing track record.

Although most traders agree thabacktesting is useful, many people dondo it because of the time, expense, anexpertise required. To produce threlatively simple backtesting reports ihis book, I spent nearly $1000 on dat

and two months part-time developinand testing the strategies.

Backtesting is not perfect. Although I’v



made the extra effort to includdividends which are typically noconsidered by commercially availabl

backtesting engines, I did not model theffects of commissions or slippageThis matters more if you trade frequentlor trade extremely large size.

Since most tactics in this book result irather limited account activitycommissions probably do not play huge role in the performance of thstrategies in this book. In fact, at th

ime of this writing Fidelity Investments offering commission-free trades o

most iShares ETFs which are thnstruments of choice to implement thi



rotation strategy. So the effects ocommissions should be insignificant.

Other inaccuracies that may affect thresults include my tactic of simulatinhe execution of buy/sell orders each da

at the close, and assuming we get thclosing price. Strictly speaking, this ipeeking because we really can’t knowhe closing value until it is too late trade.

n practice, however, many of us checfor trading signals at 3:30pm easterime and squeeze in an order just beforhe close. Another approach for end-of

day trading is to set a limit order for th



next day’s open based on the closinprice on the day of the signal. This cabe a leisurely way to avoid slippage

until the market moves quickly and thrader is forced to play catch up.

Backtesting is not reality. It is a modeof reality – like a flight simulator. expect professional pilots to gaiexperience in a flight simulator, evehough all the nuances of aviation are no

modeled exactly. Just because a pilodoes well in the simulator, it’s n

guarantee that he/she won’t make aerror in the air. But I really do not wano ride with a pilot that persistentl

crashes the flight simulator!



So it is with backtesting. It can tell ustrategies to avoid – that’s for sure. Astrategy that passes backtesting qualifie

for further investigation and controlleforward-testing before a prudennvestor puts much capital behind it

And even then, it’s wise to expect thcompletely unexpected and sizaccordingly.



How Index-Makers Rule

Since making relative comparisons is thway to assess market strategies, the firshing to do is establish a baseline fo

comparison. In the case of absolutreturns, the baseline becomes the “riskfree” interest rate. Unfortunately, tharate approaches zero at the moment. Fo

hose interested in beating the markesome form of market return is needed fohe baseline.

Academics and experts are quick tpoint out that the odds of doing bettehan average in the markets are slim



Just ask anybody that makes their livinrunning index funds that invest in thaverages.

Way back in time, the Dow Jones 3ndustrial Average seemed to be th

favored market proxy. With the rise ondex funds, the S&P 500 index of larg

company stocks became the poster-chilfor the stock market. I recall gettinadvice in the 1990’s to simply invest ia fund that passively mimicked thbehavior of the S&P 500 and call i

good. People piled onto the indexinbandwagon and it seemed to work well

ew funds sprouted that follow everconceivable index.



After the millennial market crash, thS&P 500 index was slow to get off thmats. Other areas of the market di

better, notably small company stocksThe Russell 2000 index is the wellknown benchmark for that segment.

Benefits of Following an Index

A key benefit of index funds is that theare diversified across many companien their designated market segment. Th

Russell 2000 spreads the risk of smalcompany ownership between 200firms. If any one of them hits the skids –which happens, especially early in th

fight to establish a market base – th



mpact on the overall index is limited.

f a company should implode altogethert is removed from the index an

replaced with a stronger contender. Nommediately, though. If the company i

still able to limp along it may be given chance to correct its deficiencies. Alsosome index-makers only realigaccording to a set schedule. Others reigger as it suits them.

Thus the indices enjoy an upwards boosfrom survivorship. The index shouldndrop to zero unless whole segments ohe market collapse. That obviousl

doesn’t mean that a stock index can



make a severe drawdown, it just meanhat it is extremely unlikely to go out o

business entirely.

Another advantage of index funds is thaou don’t spend time stock-picking

Maybe even more important to sompeople, is not second-guessinhemselves over stock picks.

At the Mercy of the Index-Makers

What helps indices, and the companien them, is that they are so widel

followed. Individual companies benef

from inclusion in an index becaus



everyone investing with index fundbrings a higher level of sponsorship the companies that comprise the index

This is no secret.

For example, on August 29, 2012, Sear

was removed from the S&P 500 becaust was deemed that its public float wa

not up to snuff. LYB was chosen as threplacement with no reason given. Thnews was announced before the markeopened and at the open SHLD was dow4% while LYB jumped the sam

amount. The next day, SHLD, left tfend for itself, dropped 0.13%. LYBmmediately got in line with its new

brethren and closed up 0.47% compare



o SPY 0.44% gain on the day.

Tracking the two days surrounding onndex change does not constitute

comprehensive study. I just bring it uo illustrate the point. Apparently th

market makers believed 4% was thvalue of being included in the S&P 50ndex. 4%! No wonder few active fun

managers can beat the index!

The not-so-good news is that we stil

haven’t gotten away from people pickinstocks. There is no God-given list ocompanies that make up each indexnstead there are sets of rules an

committees of people that pick th



companies that go in or out.

The proponents of index funds made great case that people have difficultpicking stocks that go up. Unfortunatelyhat case applies to the index too

Warren Buffet once remarked that whehe tide goes out, we get to see who i

swimming naked.

The implicit stock-picking methods ohe index-makers look good now, whil

ndex-following is favored bnstitutional and individual investoralike. Should indices fall from favorhe story may be different.



For now, it seems reasonable to followhe herd following the indices. Just staalert to scandals that may cause

stampede away from indexing.



How to Create a Diversified

Portfolio

This chapter defines a basic diversifiebuy-and-hold portfolio. Because thportfolio may turn out to be the bedrocof your investment strategy, the basi

steps for creating and maintaining diversified portfolio are laid out.

hy Use a Diversified Portfolio as Reference for Comparison



The difficulty with using any one indeas the baseline for comparison is thasometimes it represented the marke

well, other times not. In other wordssometimes it was the place to be, otheimes not.

Those who know we don’t know iadvance which asset class will do weloften hedge their bets by diversifyinheir portfolio across many asse

classes. Stocks, bonds, and real estatare the three primary choices. O

course, commodities, convertibles, anventure capital can be added to the mixparticularly for high net wortndividuals. Index funds now make tha



easy for anyone to dabble in all thcategories.

The two main advantages of using diversified portfolio as our baseline focomparison are that it sets a hig

standard to beat and enables us to learmore about the basic skill of portfolimanagement. Also, by choosing reference portfolio of index funds, wcan make a direct comparison betweehe static buy-and-hold approach an

strategies for rotation among the asse

classes.

Altering the composition of the portfoli

becomes the basis for risk-on / risk-off



Risk-on is achieved by adding more ohe asset types deemed as risky-but

rewarding during situations where w

have reason to believe taking on the riswill pay off more than usual. Risk-off iachieved by reducing the risky assetand emphasizing the asset classebelieved to carry less market risk.

“Risk-on / risk-off” connotes extremeof being completely in or completely ouof the market. While that is sometimehe case, it is perhaps more ofte

advantageous to hedge our bets because



Markets have a random componen

and really anything could happen.

Signals are mixed and murky mos

of the time.

Distinct markets may be relativel

uncorrelated much of the time, e.gstocks and bonds.

A hard-core risk-on / risk-off whicanks funds completely out of the marke

became fashionable after repeatedl

finding that in market crashes everythinplummets together. For examplecommodities and stocks may movndependently much of the time



However, once the margin calls kick iduring a crash, commodities and stockrace each other to the bottom. Late

volumes in the Beat the Crash series obooks will explore indicators to detecwhen to get completely out of the marke

hat Asset Classes to Include in th

Model Portfolio

Studies2 show that the choice of asseclasses can make a big difference i

returns down the road. History recordhow various asset classes performed ihe past and that’s one factor t

consider. Knowing that PAST

PERFORMANCE DOES NOT

http://www.cfapubs.org/doi/abs/10.2469/faj.v66.n2.4



GUARANTEE FUTURE RESULTSet’s tune in to our individual goals t

help with the decision.

My goals for this book are to create basic model portfolio that everyone ca

understand and use for comparisopurposes.

f you’re at a place financially wherou are reading investment books, yo

probably have a good-sized nest egg t

nvest, and you probably own reaestate. Any financial advisor woulalso tell you that you need a casaccount for emergencies. Therefore,

am keeping those out of the mode



portfolio, even though I think it’s a goodea to hold some cash and real estate

and in fact I do both.

My personal situation is that I’ve got fair amount of gold tucked away in

bank vault – a legacy from dark dayfollowing a perma-bear advisor. So, awith real estate, I don’t have the need trepresent commodities in my portfolioYes, I agree it would be better to have

diversified set of commodities but I’not there yet.)

Your goals will be different than mineConsider your situation carefully whe

deciding on your own portfolio. Fo



more background information oportfolio management, see the ReadinList.

The assets I chose for a well-roundeModel Portfolio are:

US Large-Cap Stocks

US Small-Cap Stocks

International Developed Market

Stocks

International Emerging Market

Stocks

http://backtestingblog.com/order/books/



US Bonds

Tactics for Implementing a Diversifie

Portfolio

To implement the portfolio, we have thfollowing choices:

Hold individual stocks, bonds

real estate in a mix thacorresponds to the recommendesplit between domestic aninternational markets.



Rely on a fund manager to pic

individual instruments tha

represent each asset class. Rely on indices that track th

stock, bond, and real estat

markets. This choice can bimplemented with either

Mutual funds

Exchange Traded Fund

(ETFs)

Recognize that owning a house an

maintaining a reserve account foits upkeep probably more thasatisfies the requirements for rea

estate and cash in the portfolio



Then only the stock and bon portions need to be represented bmutual funds or ETFs.

For the purpose of backtesting, it makesense to use mutual funds to capture th

most history and ETFs to model what aactive investor might actually useHowever, for your actual portfolio, yomight want to consider the trade-offs.

The advantages of index funds – whethe

hey are ETFs or mutual funds – waoutlined in the previous chapter (Howndex-Makers Rule ).



The advantage of owning individuastocks is that if you hone your stockpicking techniques, you might wind u

with winners that out-perform thndices and carry your portfolio t

greater glory with less tax liability. Ohe other hand, picking dogs or hangin

onto to winners until they turn into dogcan cost you. In fact, individuacompanies can disappear entirely

eaving stockholders with nothing but ax write-off.

The advantage of owning individuabonds is that you can just hold onto themreceiving dividends until maturity wheou get the principal back. Compare t



bond funds where the price of the funchanges in response to interest ratesYes, the market value of the bon

changes over time too but you can jusgnore it if you’re intent on holding unti

maturity. The down side shows if yopick a bond that defaults on itobligations: doesn’t pay its interestdoesn’t return its principal. Bond fundmake it easier to diversify agains

defaults.

Matching Funds to Asset Classes

For the backtesting reference portfoliohere’s a list of funds which represent th

chosen asset classes. Figure 1 is easy t



read at a glance. If your reader rendert in super-fine print, you can click it t

bring up an enlarged version. If you lac

he patience for all of that, no worrieshe choices are detailed in plain word

below.



Figure 1 – Asset Classes and TickersVisit website to download all graphics

For US large-cap stocks, the S&P 500 ihe undisputed choice. SPY, whicracks the S&P 500, is typically the ETF

with the highest volume. No one ioffering to let you trade that one fofree! IVV is an ETF from iShares tharacks the S&P 500, which trade

commission-free at Fidelity Investmentat the time of this writing). Whemplementing the US Large-Cap stock

with mutual funds, I chose VFINX – thVanguard fund that started it all.

For US small-cap stocks, three differen

http://truthaboutetfrotation.com/book-owners/

http://truthaboutetfrotation.com/wp-content/uploads/2012/10/Fig1-Tickers_TruthAboutETFRotation.png



ndices represent the space. The Russel2000 is probably the most popular aWM ranks among the top ETFs b

volume. S&P also keeps the S&PSmall-Cap 600® index. For mutuafunds, again Vanguard has the longeshistory of small-cap indexing wit

AESX, which tracks the MSCI USmall-Cap 1750.

For International Developed MarketStocks, the EFA exchange traded funracks the MSCI EAFE® index. Righ

now, the Fidelity fund FSIIX passivelracks that same index. Unfortunately, nnternational fund on exactly that inde

has quite enough history for backtesting



The closest match is VGTSX whicdoes allow us to backtest from 1998 buactually follows the MSCI All Countr

World ex-USA Investable Market IndexThe upshot is that the model portfoliemphasizes emerging markets a littlmore in mutual funds than it does iETFs.

nternational Emerging Markets Stockare tracked by the ETF from iSharewith ticker EEM and the Vanguard funVEIEX, which both follow the MSC

Emerging Markets index. Note that withese index funds, we can invest i

markets worldwide without taking thime to become familiar with thei



anguages and stock exchanges.

US Bonds are represented by thBarclays U.S. Aggregate Bond Indexwhich is tracked by the iShares AGGexchange traded fund. VBMFX is th

Vanguard fund counterpart. This bonndex has a duration of 5-10 years whic

makes it less speculative than lonbonds and more lively than short-ter notes. It also features a mix of corporatand treasury bonds.

hat Percentage to Invest in Eac

Asset Class



ow that we’ve decided on our asseclasses, the next question is how much tnvest in each.

Professional portfolios managerallocate their assets by computin

percentages according to their model orisk/reward. The Nobel-Prize winnin

Modern Portfolio Theory (MPT)3 take

advantage of the lack of correlatioamong diversified assets to create aoptimal portfolio in terms of expectereturn for a given risk. Or, for a give

risk tolerance, MPT can help find thportfolio weighting that produces thhighest expected return.

http://www.jstor.org/stable/2975974



As an aside, MPT relies on values fovolatility, correlation, beta, and eveexpected return that are typicall

derived from historical price data. It ipossible to plug in truly forward-lookinexpected returns, say by calculating price as discounted cash flow of thunderlying company but almost everyonooks in the rearview mirror fo

volatility and correlation.

Further complicating mattersprofessional suggestions for individuals

portfolios include a notion of investmenhorizon. They generally recommenputting more coin in stocks when one ioung and directing a greater proportio



of dollars to bonds in later years wheone favors stability and income.

One rule of thumb is that the percentagof your portfolio in bonds should equaour age. Stock index fund proponent

call that conservative though. 4

Detailing the models is beyond the scopof this report but keep in mind thesmethods result in dynamic portfoliallocations that change with the pas

performance of the market and thcurrent needs of the investor.

Of course, many popular money guide

http://www.kiplinger.com/columns/fundwatch/archive/a-twofund-portfolio.html



give a simplistic one-size-fits-alnvestment allocation. For the purpos

of a reference portfolio, I will calculat

he returns on a several data points anuse the middle one as the baseline goinforward.

Setting up the Reference Portfolio

Getting started is easy. Finding thnumber of shares to buy for each elemenof the portfolio is a simple calculation

On the start date, for each fund, jusmultiply the account balance by thpercentage allocated to the fund, anhen divide by the current price of th

fund. Round down to get the number o



shares to buy.

For backtesting, I took the closing pricon the start date. For real execution witETFs or mutual funds, you may not bable to get that closing price due t

slippage.

Slippage is the difference between th

ast quoted price and the actual pricpaid. With mutual funds, there is nslippage because everyone gets the sam

price – the Net Asset Value (NAV) at thclose of trading. However, if you placan order after the market closes for thday, it will be filled at the next day’

close of business, which is probably



different price.

Since ETFs trade like stocks, they hava price spread between the bid price anhe asking price. If your quantity iarge, you might absorb all the shares a

he bid/ask and actually move the markewith your order. That is slippage.

Limit orders can help slippage becaushey specify a set price for thransaction. In practice with thinl

raded instruments, a limit order oftemeans waiting until the market slips faenough past the set price that the markemaker can scalp a profit by acceptin

our order. In some cases, the marke



may not come back to your limit priceeaving you to jump in with mor

slippage than if you’d just entered at th

market price.

n markets with wide spreads and gentl

movements, or very fast markets, yowill probably find slippagunavoidable. I did not model slippagor commissions in the backtesting.

Rebalancing to Maintain the Portfolio

My initial back-tests on portfolios -published in earlier article an

presentations -- did not includ



rebalancing. It was only aftecontemplating the need for rebalancinn an ETF rotation strategy that I came t

understand the benefits of rebalancinand actually implemented them in mbacktesting tools. Now all my portfolisimulations include rebalancing.

Rebalancing is the cheat for buy-andhold strategy advocates, allowing theo participate in more market action tha

simply allocating funds one time anetting her run. It is necessary becaus

he more successful assets will come tdominate the portfolio over time whicwrecks the diversification. The reason call it a “cheat” is that it allows the buy



and-hold investor to take profits froassets that are up and buy into lesseperformers, like a value investor migh

do.



Performance of Buy-and

Hold of Diversified

Portfolios

Figure 2 below brings together th

performance metrics for diversifieportfolios with various stock/bonbalances from a historical simulation o

mutual funds held and rebalanced fro1998 – 2011.

The top line lists the stock/bonbreakdown. For example, 70 / 30 mean70% stocks and 30% bonds. The stocallocation is split equally for each of ou

previous four categories of US large

http://truthaboutetfrotation.com/wp-content/uploads/2012/10/Fig2-BnHAllocationExploration_TruthAboutETFRotation.png




cap, US small cap, developed marketand emerging markets. In our examplehe 70% allocation to stocks is split wit

17.5% of the total account going to eacstock fund.

The portfolio simulator purchased thmutual funds in this proportion on thstart date and then rebalanced on the firsrading day in January of eac

subsequent year. Comprehensivmetrics are reported in the table. Amore detailed description of the metric

s in the chapter on How to Comparnvestment Strategies.





Figure 2 – Buy-and-Hold Portfoli

Allocation ExplorationVisit website to download all graphicand trade-by-trade backtesting data

Commentary on Mutual Fun

Portfolio

The array of results lets us compare theffects of adding more bonds to portfolio. Of course, going forward thnumbers won’t be the same, but we castill learn from relative comparisonsince each experiment in Figure 2 wa

run on 1998 – 2011.






First off, notice that consistently acroshe board the max drawdown (Max DD

%) decreased as more bonds wer

added to the portfolio. This is graphen Figure 3. The percentage of stock v

bonds in the portfolio is marked oualong the bottom. The amount of stock ihe portfolio decreases as we move lefo right in the graph. Since drawdown ia negative number which becomes les

negative as more bonds are added to thportfolio, the line goes up and to thright in Figure 3.

http://truthaboutetfrotation.com/wp-content/uploads/2012/10/Fig3-MaxDDPortfolios_TruthAboutETFRotation.png






Figure 3 – Maximum Drawdown o

Portfolio Exploration

nterestingly enough, the CAGR als

ncreased when going from the extremof 90% stocks to the balanced situatioof 50% stocks / 50% bonds. Addinmore bonds than 50% again decrease

he CAGR but also decreased the madrawdown. See Figure 4.

http://truthaboutetfrotation.com/wp-content/uploads/2012/10/Fig4-CAGRPortfolios_TruthAboutETFRotation.png






Figure 4 – CAGR of Portfoli

Exploration

The average annual returns wer

consistently decreasing with less stocn the portfolio. This discrepancy withe actual profit (row 3 of Figure 2) iwhy average annual returns ar

presented in smaller print than CAGRThe average of all the years together caobscure the order dependency of return

getting a profit before a loss is bettehan taking a loss then profit because ihe latter case, the profit comes on

smaller account balance). Figure

shows graphically how the averag

http://truthaboutetfrotation.com/wp-content/uploads/2012/10/Fig5-AvgAnnReturnPortfolios_TruthAboutETFRotation.png


http://truthaboutetfrotation.com/wp-content/uploads/2012/10/Fig4-CAGRPortfolios_TruthAboutETFRotation.png



annual returns changed with more bondn the portfolio.





Figure 5 – Avg Annual Return oPortfolio Exploration

Volatility went down with more bonds –hat was the point. You can see th

effect that had on the Sharpe ratio i

Figure 6, whose annual values only goabove 1 for the case of 20% stocks an80% bonds. Clearly this was a tougime period to hold onto stocks, eve

with a diversified portfolio.

http://truthaboutetfrotation.com/wp-content/uploads/2012/10/Fig6-SharpePortfolios_TruthAboutETFRotation.png

http://truthaboutetfrotation.com/wp-content/uploads/2012/10/Fig5-AvgAnnReturnPortfolios_TruthAboutETFRotation.png





Figure 6 – Sharpe Ratios of Portfoli

Exploration

On the monthly statistics, the averag

return (in Figure 2, row 6) agaidecreased as the proportion of stockheld in the portfolio decreased. At thsame time, the volatility decreased

although the volatility for one month (iFigure 2, row 7) was more than onewelfth the yearly volatility. The resul

was that the monthly Sharpe ratios (iFigure 2, row 10) were lower than thannual Sharpe ratios (in Figure 2, row5).

http://truthaboutetfrotation.com/wp-content/uploads/2012/10/Fig6-SharpePortfolios_TruthAboutETFRotation.png



Comparing monthly Sharpe ratio tSortino ratio (in Figure 2, row 11), thSortino ratio was always greater, a

expected. The basic trend is the sameas more bonds are added to the portfolihe reward/risk ratio goes up. To say ianother way, by adding stocks to thportfolio, one gets more return and evemore risk – the risk goes up faster thahe return.

This calls to mind a favorite quote: “Aship in a harbour is safe, but that is no

what ships are for.” - John A. Shedd

Anyway, back to the statistics. Th

number of trades (In Figure 2, row 12



was never more than the number of fundn the portfolio times the number oears because each position came up fo

annual rebalancing. With smalallocations of high-priced tickers, position sometimes didn’t change in threbalancing, resulting in fewer than thheoretical maximum number of trades.

f you look at the raw trade lists on thcompanion web site, you’ll see manrades left open at the end of th

simulation. That’s because each time

few more shares were bought durinrebalancing, a new trade was createdThis makes it easier to understand whahe simulator did and also keeps track o




ax lots, which may be useful in thfuture.

As you’ll see later, some other strategieactually traded less frequently but theurned over the whole portfolio rathe

han just trading a few shares. I’ll toucon the tax implications in a moment.

The Average Hold Time is reported ibars or trading days, of which there arroughly 250 per year. The number

isted in the bottom row of Figure come out to about 7 years, which was faess than the test period. What happene

was that the few shares bought durin

rebalancing were counted a




ndependent trades and brought thaverage down.

The Win Rate (in Figure 2, row 13) waquite high for all the portfolios – ove90%. The 10/90 and 30/70 eve

reached 100% wins! Every single assen the portfolio was up from 1998 t

2011, so where did the losses comfrom? Rebalancing.

hat If You Didn’t Rebalance

Since rebalancing is a bit of a hasslewhat if we skipped it? I tested that ou

with the 50/50 stock/bond mix. As yo



can see from the rightmost column oFigure 7, not rebalancing cost 0.9% iCAGR, when taxes were no

considered. The stats in this case werslightly worse for just letting the gardegrow wild.

http://truthaboutetfrotation.com/wp-content/uploads/2012/10/Fig7-NoRebalance_TruthAboutETFRotation.png



Figure 7 – No Rebalancing

Comparison with S&P 500

http://truthaboutetfrotation.com/wp-content/uploads/2012/10/Fig7-NoRebalance_TruthAboutETFRotation.png



Okay, so I can’t resist a comparisobetween the diversified portfolios anholding only the S&P 500 for the sam

ime period, 1998 – 2011. As you casee from the right hand column of Figur2, the S&P 500 produced a 3.6%CAGR, a -55% drawdown, and aannual Sharpe ratio of only 0.14. Threturns are smaller, the drawdowdeeper, the reward/risk ratios lower.

Clearly putting everything on the S&P500 was not a big win. We have got t

find ways to do better! It appears thasimply holding / rebalancing diversified portfolio which includeother funds along with the S&P 500 i




one strategy. We will look at activstrategies, such as ETF Rotation, awell.

Report and Commentary on ETF

Portfolio from 2005 - 2011

Figure 8 shows the simulated results oapplying the exact same diversifie

portfolio strategies to the ETFs (SPYWM, EFA, EEM, AGG) over the perio

2005 – 2011. In general, the sam

relationships hold as for the longer timperiod with mutual funds so I won’t ghrough it in detail.

http://truthaboutetfrotation.com/wp-content/uploads/2012/10/Fig8r-BnHETFAllocations_TruthAboutETFRotation.png



Figure 8 – ETF Portfolio Buy-and-Hold

Visit website to download all graphicand trade-by-trade backtesting data

For 2005 – 2011, the asset allocatiohat produced the most returns with theast drawdown was 40% stocks an

60% bonds with 5.8% CAGR and -23%


http://truthaboutetfrotation.com/wp-content/uploads/2012/10/Fig8r-BnHETFAllocations_TruthAboutETFRotation.png



drawdown. The 30 / 70 portfolio diwhat looks like the same CAGR with drawdown of only -20%. Double

clicking into the trade-by-trade resultspreadsheet shows that 40 / 60 did just smidge better.

Mixing in even more bonds reduced thdrawdown further but clearly at thexpense of the CAGR. Going to thother extreme with 90% stocks and 10%bonds brought the win rate down to 83%with commensurate damage to th

CAGR and maximum drawdown.

Tax Implications of Portfoli

Adjustments




The following tax assumptions mighnot apply to you, check with your taadvisor.)

n discussing the number of trades, wnoted that rebalancing the portfoli

every year required up to one trade peicker. But those trades were often onla small percentage of the account – not complete turnover of assets. For taxablaccounts (not IRA or 401k), you mighassume the tax due to rebalancing woulbe negligible.

n fact, I made an estimate of payin15% tax - the current long-term capita

gains rate for holdings over a year whic



assumes rebalancing at least 366 dayapart. The tax impact of rebalancing oour example was 0.01% CAGR –

nothing to get excited about.

Gross-Up for After-Tax Comparisons

One of the advantages of this gentldiversified portfolio might still b

axes. To make better comparisons witmore active strategies, we can estimathe return required from an activ

strategy before taxes to match the buyand-hold strategy with a no-taassumption.



n reality, you may still owe taxes jusfor holding a mutual fund because ancapital gains taken by the mutual fun

will flow through to you. Even indefunds make adjustments such arebalancing or tracking companies thacome and go from the index. This maresult in taxes even in a buy-and-holsituation – check with your tax advisor.

The top line of Figure 9 shows the return the ideal case of no taxes. Each row

corresponds to a tax rate: 10%, 15%

25%, 28%, 33%, 35%. The intersectioof the row and columns estimates whahe taxable return would have to be t

net out to the top line return.

http://truthaboutetfrotation.com/wp-content/uploads/2012/10/Fig9-TaxGrossUp_TruthAboutETFRotation.png



Figure 9 – Tax Gross-Up

http://truthaboutetfrotation.com/wp-content/uploads/2012/10/Fig9-TaxGrossUp_TruthAboutETFRotation.png



For example, if the tax-free portfolishowed returns of 6.8%, then a fullaxable strategy that turns over its whol

portfolio within a year would have tshow a return of 9.1% to be equivalenfor an investor in a 25% tax bracket.

The Reference Portfolio or Baselin

for Comparison

The goal of this chapter was to create reference portfolio we can use as

baseline for comparison to more activstrategies. Making several backtestinruns added informative insight.



ow it’s time to pick a single portfolio be our reference for comparison. focused in on the 50/50 mix because

did the best for the longest timeframeThe actual mix of assets is shown iFigure 10.

http://truthaboutetfrotation.com/wp-content/uploads/2012/10/Fig10-RefAllocation_TruthAboutETFRotation.png



Figure 10 – Reference Portfolio AsseAllocation

Backtesting results are summarized iFigure 11 below. Figure 12 shows thear-by-year return of the referenc

portfolio as well.

http://truthaboutetfrotation.com/wp-content/uploads/2012/10/Fig12r-Yr-YrBnH_TruthAboutETFRotation.jpg

http://truthaboutetfrotation.com/wp-content/uploads/2012/10/Fig11r-5050PortSummary_TruthAboutETFRotation.jpg






Figure 11 – Reference PortfoliPerformance Summary

http://truthaboutetfrotation.com/wp-content/uploads/2012/10/Fig11r-5050PortSummary_TruthAboutETFRotation.jpg





Figure 12 – Year-by-Year Return o

Reference Portfolio

With this diversified reference portfolio

we can now move forward and makmeaningful comparisons to more activnvestment strategies.




What Could Be Better Than

Diversified Buy-and-Hold

Just sticking with the diversifieportfolio would be great – if it producemore gain with less drawdown!

One common-sense approach tmproving performance is to try to shif

capital into the top performing assets

riding the gains while staying away frohe asset classes which are languishing

To make this work, it needs to do twhings:



1. Choose asset classes early enoug

in their run that they still have rooto go up.

2. Don’t be so quick to shift asse

classes that the portfolio churnslosing with every whipsaw.

The upcoming chapters show you how tdo this rotation and how it would hav

performed historically. Starting with thassets in the diversified portfolio froast section, it builds from basic rotatioo more sophisticated techniques usin



stop losses, plus additional asset classeike short funds, cash, long bonds, an

commodities.



How to Do an ETF Rotation

Rules for rotation are necessary to makhis experiment – and actual trading –

objective and repeatable. Early rotatiostrategies, especially among sectors ohe stock market, attempted to track th

current status of the economic anbusiness cycles and shift into areas thashould experience growth during thcurrent phase. This is extremel

difficult to forecast, even amoneconomic experts. For exampleeconomists don’t officially declare recession until months after it ha



begun. By then, the stock market haong since priced it in. Also, it i

difficult to backtest such judgment calls.

A simpler, more objective approach is tmeasure the funds’ performance a

regular intervals and get into those tharank highest. As mentioned above, evehough we want to always be in the bes

funds, it is necessary to give them a littlbreathing room, by allowing a top funo place anywhere in the top half befor

replacing it with a stronger candidate.

The Rate of Change (RoC), which isimply the total return in percentag

form, is my preferred metric to selec



funds because it is easy to understandquick to calculate, objective, andirectly related to performance. A ke

question, which is answered in the nexsection, is: how far back does one go tcalculate the percentage gain forotation?

Basic Rotation Rules

Before we get to the test results, let’s ghrough the rotation process in detail

The rotation rules I currently preferwhich were used for this report unlesstated otherwise are:



1. Each week, calculate th

percentage total return (includin

dividends) for each fund.2. Rank the funds and note

1. The top two

2. The cut-off for the top half

3. If the account is 100% cash, spli

the account 50/50 between the toptwo funds.

4. If a currently held ETF is in th

top half, hold it.

5. If a currently held ETF is not i

the top half, then sell it.



6. With significant money availabl

to invest (usually from the sale i

step 5), buy the highest performinfund not already owned. The new purchase should be one of the totwo ETFs from step 2a. That is,

1. If not already in the top ETF

buy it.

2. If already in the top ETF, buthe #2 ETF on the list

3. If 100% cash, split 50/50 t

buy into the top 2 funds.

4. Re-balance annually to 50/5

split of the top 2 funds.



This method stays invested in the top performers, allowing them to breathe bonly selling a fund if it falls into th

bottom half of the list. When a fundrops to the bottom half, a replacemens picked from the top of the list. I

never doubles into an existing fund but ialways invested in two different funds.

For backtesting, the price data idividend-adjusted in such a way that appears that dividends werautomatically re-invested on th

dividend day at the current price with ncommission. That’s not entirelrealistic. First off, not all brokers wilallow a commission-free dividen



reinvestment. Secondly, it’s possible thold an ETF through the dividenrecording date, but rotate out before th

dividend is paid, resulting in a casbalance in the account. Personally, I jushold dividends in cash until the nexrotation opportunity.



Performance of R otation o

Reference Portfolio

One of the key questions from thprevious section was how far to looback to calculate the percentage gain iorder to decide which f unds to pick

Fortunately, computers ar e fast workerand we can quickly check severareasonable settings.

The results of rotating among the mutuafunds used for the reference portfolifrom 1998 – 2011 are shown in Figur

http://truthaboutetfrotation.com/wp-content/uploads/2012/10/Fig13-RotationLookBack_Gray_TruthAboutETFRotation.png











13. Keep in mind this is a hypotheticasimulation – the mutual fund companwould never let you rotate in and out o

he funds like this. We are using mutuafunds in the back-test because theihistory goes back beyond 1998.

The top section in Figure 13 plots thCompound Annual Growth RateCAGR) for the rotation strategy in dar

gray and buy-and-hold of the diversifiereference portfolio in black. Thookback settings go from 20 to 30

rading days, increasing in increments o10.

At a glance, you can see that all setting




of the rotation produced higher returnhan holding the reference portfolio

Both the rotation and the referenc

portfolio have the same assets. Thdifference is in rotating according tsimple rules which historicallproduced better CAGR.

The bottom of Figure 13 shows different story. This is the drawdownexpressed as negative numbers. In evercase but one, this simple rotatiostrategy - plotted as the light gray line

demonstrated more volatility ameasured by a deeper drawdown thahe reference portfolio - plotted as th

solid black line.




The dotted black line at the very bottos the drawdown of the S&P 500racked by VFINX. In every case, th

rotation strategy was superior tpassively holding the large-cap indefund.





Figure 13 – Rotation Lookback Settings

Visit website to download all graphicand trade-by-trade backtesting data

n practice, we need to select just onsetting for the lookback period. We neehat for live trading, and to make the res

of the book manageable. To guar

against over-optimization, pick a settinhat is among a plateau of good setting

rather than an isolated peak.

Choosing 140 trading days (between siand seven calendar months) as th

ookback period to calculate th





percentage gain appears to meet thacriterion. Many charting packages wilcalculate this as a 140-bar RoC – th

difficulty is in getting them to operate ootal return data. You can download a

open source spreadsheet that makes thicalculation from my site aruthaboutetfrotation.com.

140-day RoC Rotation Results

A detailed comparison to the referenc

portfolio of the 140-day rotation fomutual funds and for ETFs is shown iFigure 14. As above, the CAGR ibetter but the drawdown is worse fo

rotation. The Sharpe ratio is a singl

http://truthaboutetfrotation.com/wp-content/uploads/2012/10/Fig14r-RotationStats_TruthAboutETFRotation.jpg




metric that balances both the risk anreward. In Figure 14 you can see thahe rotation strategies produced a bette

Sharpe ratio than buy-and-hold.






Figure 14 – Simulated Rotatio

PerformanceVisit website to download all graphicand trade-by-trade backtesting data

The number of trades for the rotatiostrategy was roughly three times that obuy-and-hold. The win rate droppe

considerably, and the size of the windecreased as well. The rotation strategost a greater percentage of the time

Overall, however, the rotation strategaccumulated more gains, as evidenceby the higher CAGR.





The average number of bars held at thbottom of Figure 14 shows that throtation strategies stuck with one fun

for an average of less than 60 tradindays. This is about 12 weeks or oncalendar quarter. We can expect the fulportfolio to turn over within a year anso should assume all gains would baxed at the short term rate, if held in axable account.

f held in an IRA and traded with limorders at a broker that offers

commission-free arrangement, thurnover doesn’t necessarily add t

overhead.




Tax Considerations

One of the oft-cited benefits of buy-andhold is tax considerations. Referrinback to the “gross-up” table in Figur10, to come out ahead a mutual fun

rotation strategy would need to producgains of 9.1% for a middle (25%) tabracket and 10.5% for the top federa

36%) tax bracket. The 140-day rotatiocame in at 11.6% to stay ahead afteaxes. For the ETF portfolios over 200– 2011, buy-and-hold produced 5.8%

CAGR and rotation got 9.3% CAGRbefore taxes. 5.8% grosses up to 8.8%at a high federal tax rate so the rotatioust squeaked by, and in fact may not b




viable for a taxpayer in the top brackewith state tax to contend with besides.

For most tax brackets, however, I thinhis shows that running a rotatio

strategy in an after-tax account is not ou

of the question. Of course, youpersonal situation may be differenconsult your tax advisor.

Year-by-Year Returns

Year-by-year total returns are reporten Figure 15. Comparing back to Figur

12 for the reference portfolio give

nsight into how rotation produce


http://truthaboutetfrotation.com/wp-content/uploads/2012/10/Fig15r-RotationYrByYr_TruthAboutETFRotation.jpg



higher gains with greater volatility.





Figure 15 – Year-by-Year Performanceof Basic Rotation Strategy

n two of the four down years, throtation did considerably worse. I2000, the buy-and-hold portfolio onl

gave up 1% overall while the rotatioost 12%. Again in 2002, buy-and-hol

gave up 3.6% compared to 10.5% losfor rotation. Neither did well in 2008with comparable losses of 18.2% fomutual funds and 16.6% for ETFsFinally, in 2011 both methods showe

small losses.

n the profitable years rotation made up

for any losses. Only in 2004 and 201

http://truthaboutetfrotation.com/wp-content/uploads/2012/10/Fig15r-RotationYrByYr_TruthAboutETFRotation.jpg



did sitting on the diversified portfolimake more money than the rotationRotating the mutual funds often showe

more than twice the gains, however, thstrategy is too active to carry out omutual funds. With the ETFs, thsuperiority is less pronounced but stilvery evident. In 2005 -2007, throtation blasted out roughly 19% peear while buy-and-hold spent two o

hose years with single digit gains.

2009 produced curious results: 42%

versus 24% with mutual funds, 28%versus 19% with ETFs for rotatioversus buy-and-hold respectively. Firsof all, why the differences betwee





of 56% for VEIEX or on 2/10/10 for gain of 50% on EEM. In just this onrade, there was a 6% difference i

performance between VEIEX and EEM

This example also illustrates the valu

of rebalancing because roughly 15% iprofits dissipated between the annuarebalancing exit and the rotation tanother fund. Experiments with morfrequent rebalancing are reported in ater chapter (Does Active Rebalancin

Help Grab Profits?).

Overall, the backtesting tended tvalidate the rotation strategy over buy

and-hold for all but the most tax



sensitive traders.



What If You Don’t Own a

Home?

nvestors who don’t own a home, or whwant more exposure to the real estatasset class, may be curious to see whahappens with the rotation strategy whe

a real estate fund is added.

To produce Figure 16, the same rule

were applied to the same funds as Figur13, except that FRESX was added to thmix. FRESX is a Fidelity mutual funhat focuses on real estate companies



http://truthaboutetfrotation.com/wp-content/uploads/2012/10/Fig16-RotaStatsRealEstate_Gray_TruthAboutETFRotation.png



both domestic to the United States annternational. It was chosen because is one of the few pure real estate fund

dating back to the 1990s. In recenears, FRESX performance wa

generally higher than IYR, an ETF tharacks a real estate index.





Figure 16 – Rotation Performance b

Lookback Period with Real Estate

As before, the dark gray line in Figur

16 shows the CAGR of the rotatiostrategy for various settings. The lighgray line plots the drawdown. Comparo the solid black lines for th

performance of the reference portfolioThe dashed line is the S&P 50

drawdown.

The general results are about the samwith real estate as without: the rotatio

strategy produced higher returns but wit





worse drawdown. With real estate, iappears that the sweet spot for thookback period grows to 160 days.



Which Day of the Week to

Rotate?

Most of the runs for this book rotated thETFs on Thursday, using the closinprice on Thursday. What happened if different day of the week was adopted?

ot much difference, according tFigure 17.

http://truthaboutetfrotation.com/wp-content/uploads/2012/10/Fig17-DayOfWeek_TruthAboutETFRotation.png



Figure 17 – Day of the WeeComparison

Wednesday came out on top with 13.9% CAGR. Monday was the laggarat 12.6% CAGR, confirming it

reputation as a hard day. Thursda




placed second with 13.7% CAGR.

o surprises in these results. That thewere clustered together suggests this is robust strategy. A wide variation woulbe a red flag. However, it is extremel

unlikely that all days of the week woulproduce exactly the same statistics. Onof the days has to come out on top and happened to be Wednesday in thiexperiment.

don’t know of a good reason whWednesday should stay on top, yet afteseeing Figure 17, I’m making my rotatiorades based on the closing price o

Wednesday.




Since the closing prices and ranking arnot necessarily known in time to place real trade, I enter limit orders to execut

on Thursday, pegged to the closinprices on Wednesday. This also serveo contain slippage. If my limit order inot filled by the end of the day Thursday will change it to a market order to b

sure the trade happens.



Bring on the Long

Bonds

Our basic list of ETFs to rotate consist

of four stock funds and one bond fundWith this mix, it is never possible to geentirely out of the stock market during downdraft.

Adding another bond fund changes thaby giving two safe havens from the stoc

market. We’ll later look at rotating tcash. For now, funds that track the lonUS Treasury bonds will serve. Tmplement this from the historica



perspective the VUSTX mutual funfrom Vanguard was included in the backest. For more recent perspective an

ive trading the ETF from iShares, TLTs the choice.

Figure 18 shows the results of applyinhe same rotation rules to the mutua

funds (VFINX, NAESX, VEIEXVGTSX, VBMFX, VUSTX) during 199– 2011. Then the ETFs (SPY, IWMEEM, EFA, AGG, TLT) were backtesteduring 2005 – 2011. One more tim

period, 2009 – 2011, was added iorder to see how the strategy workeately.

http://truthaboutetfrotation.com/wp-content/uploads/2012/10/Fig18dd-LongBonds_TruthAboutETFRotation.jpg



Figure 18 – Rotation with Long Bonds

In head-to-head comparison




we can see that including the

long bond funds, VUSTX o

TLT, added value early on byboosting CAGR from 11.6% to

13.5% and reducing

drawdowns from -35% to-20.9% for the mutual fund

during 1998 – 2011. Evenmore impressive: with the

ETFs from 2005 – 2011 the

CAGR jumped from 9.3% to15.8% while the drawdown

dropped from -34% to -21%.



From 2009 – 2011, when the

stock market largely went up

occasionally rotating into TLTslightly increased CAGR from

9.7% to 10.1% and allowed a

max drawdown of -15.1%compared to -16%.



Shorting the Marke

with Inverse Funds

The next series of comparisons take

place between 2007 and 2011 becaushat’s when index fund ETFs becamavailable to track commodities and shorfunds. (Yes, inverse mutual funds wer

available sooner but the overhead oracking many different time periods wa

getting too much.) The second and thircolumns of Figure 19 are reruns in th

2007 – 2011 time period to give pointfor comparison.

http://truthaboutetfrotation.com/wp-content/uploads/2012/10/Fig19dd-CommShortAll_TruthAboutETFRotation.jpg



As you can see comparing the third anfourth columns of Figure 19 TLT doebetter than inverse fund SH as a fift

wheel in the rotation strategy. TLT icolumn 3 produced a 13.2% CAGR witalmost -15% max drawdown.

SH moved a couple percentage points ihe wrong direction with 11.2% CAGR

and -17.7% max drawdown. Includinboth SH and TLT brought the CAGR uslightly to 14.2% with a slighworsening of max drawdown t

16.8%. Note that the basic ETFrotation performance came in at 5.4%CAGR with -34% drawdown during thivery tough time period.




Adding both TLT and SH improved thsituation during the 2008 credit crisis.

Figure 19 – Including an Inverse Fund toShort the Market




How About Those

Commodities?

Commodities have the potential fo

gain. Unfortunately, they bring volatilitwith them. Column 6 in Figure 1above, shows that adding commoditndex fund DBC to the basic ETF mi

during 2007 – 2011 improved CAGR t9% -- above the basic ETFs but belowSH and/or TLT. The max drawdown hinew lows at -41% though.






Everything But the

Kitchen Sink

Bringing a full complement of ETFs

SPY, IWM, EEM, EFA, AGG, TLT, SHDBC – boosted the CAGR to 15.5%while widening the max drawdown t21.8%. See the rightmost column i

Figure 19. Clearly, tinkering with thist of ETFs produced gains with slighncreases in volatility.

Comparing back to buy-and-hold of diversified portfolio continued to showhe benefits of rotation. In this case





Figure 20 shows backtests for 2007 2011 where the reference portfolio o50% stock index funds and 50% AGG

bond fund brought in only 3.8% CAGRwith a whopping -30% max drawdown.

http://truthaboutetfrotation.com/wp-content/uploads/2012/10/Fig20r-Ref2007_TruthAboutETFRotation.jpg





Figure 20 – Buy-and-Hold ReferencePortfolio 2007-2011

Splitting the bond allocation betweeAGG’s broad spectrum and TLT’s focuon 20-year treasuries helped somewha

by creating a CAGR of 5.8% with 27% drawdown. Making room fo

commodities was not worth the effort ahe CAGR came in at 4% with a -38%

max drawdown.

http://truthaboutetfrotation.com/wp-content/uploads/2012/10/Fig20r-Ref2007_TruthAboutETFRotation.jpg



Rotating to Cash when

Everything Rots

The previous sections demonstrated th

benefits of being able to completely takmoney out of the stock market ooccasion. Allocating assets to bonfunds or even short funds both increase

he returns and decreased the maximudrawdown.

However, bond funds, especially lonbonds such as 20-year treasury bonds iTLT, can be volatile themselves. Thprice of a long-term bond is sensitive t



nterest rates and other factors. It is norisk free. “Risk-free Treasuries” refero short-term Treasury Bills which d

not fluctuate much during their brieifespan.

nverse funds are not only volatile; thecome with higher built-in expensesWorse, an inverse fund is not designed track the market for long periods; the

only try to offset the daily behavior ohe underlying index.

What if we simply hold assets in caswhen the funds are not performing well?When the percentage gain over the las

140 trading days falls below zero,



says the fund has lost money on antermediate-term basis. We can takhat as a signal to move to cash.

The revised rules for rotation, includina safe haven in cash, are:

1. Each week, calculate th percentage total return (includindividends) for each fund.

2. Rank the funds and note

1. The top two




3. Which funds have positiv

gains over the past 140-days

3. If the account is 100% cash, spli

the account 50/50 between the toptwo funds which have positiv

performance over the past 140days. If no funds have positiv performance, just stay in cash.

4. If a currently held ETF is in thtop half with positive gains, hold it


the top half, or is not showin positive gains, then sell it.

6. With money available to inves

(usually from the sale in step 5)



buy the highest performing fund noalready owned with positive gainsThe new purchase should be one o

the top two ETFs from step 2aThat is:


and the top ETF had positivgains, buy it.

2. If already in the top ETF, bu

the #2 ETF on the list, if it ha positive gains.


buy into the top 2 funds wit positive gains.

4. Re-balance annually to 50/5



split of the top 2 funds wit positive gains.

Doing the full-scale backtest resulted ihe statistics in Figure 21. The secon

and third columns show the results o

rotating among mutual funds and cash fohe period 1998 – 2011.

Relying on only the basic funds (VFINXAESX, VEIEX, VGTSX, VBMFX

with cash added did better but wit

higher drawdown than including lonbonds via VUSTX.

To see where using cash as an asse

http://truthaboutetfrotation.com/wp-content/uploads/2012/10/Fig21dd-CashRotation_TruthAboutETFRotation.jpg



mproved the results, compare thbasic+cash run with CAGR of 11% anmax drawdown of -28% with th

original rotation in Figure 14 whicproduced a similar CAGR of 11% bumuch worse drawdown of -35%.

However, Figure 18 showed 13.5%CAGR and -20.9% max drawdown forotation among basic mutual funds anhe long bond fund VUSTX. That turne

out to be a better performance thancluding both cash and long bonds a

shown in Figure 21, column 2.






Figure 21 – Cash as an Asset in Rotation

Using ETFs for the period 2005 – 201

again showed that adding cash to thmenu of choices reduced the madrawdown from -34% to -22.8% and ahe same time the CAGR crept up fro

9.3%. to 10.8%. However, from Figur





18 we saw that rotation among the BasiETFs + TLT produced a CAGR o15.8% with -21% drawdown.

During 2007 – 2011 the results with anwithout cash are about the same

suggesting that some of the funds alwaygained during that time. This perioncluded the 2008 credit crisis in whic

TLT soared while the stock markecrashed.

So we must conclude that rotating tcash did not always get the best or safesperformance. Selecting the right mix ofunds produced better results. In a late

chapter which double-checks the asse



mix over a longer time period, thbenefits of cash rotation were even lesclear. Cash rotation also bring

additional steps in a slightly morcomplicated set of rules for rotation.

However, cash rotation limited thdrawdowns without making a negativmpact on returns with the basic set o

funds. It is worthwhile to include casas an asset class in the rotation becauswe have no guarantee that the same fundwill outperform in the future. In the nex

crash, it may not be TLT that representsafe haven and then cash might be welcome respite from the markets.



What Happened with

Stop Losses

Attempting to shave the drawdowns wit

stop losses was not very effective. SeFigure 22 for data. All runs used thbasic set of mutual funds with cash as aasset class, over the timeframe 1998

2011. The stop loss was set at a fixepercentage below the entry price anriggered a sale if the stop price was h

while the fund was held.

http://truthaboutetfrotation.com/wp-content/uploads/2012/10/Fig22dd-StopLossCash_TruthAboutETFRotation.jpg




Figure 22 – Rotation with Stop Losseand Cash as an Asset

n general, the performance sufferedThe CAGR went down and yet thdrawdown got worse. This illustratehe effects of thrashing between funds a

hey take short-term pullbacks. At 10%




and even 15% stop losses the gains werpinched without any improvement in thdrawdown.

Stop losses of 20% and 25% produceexactly the same results as th

unconstrained runs with cash as an asseclass. This means the stops were nevehit when placed 20% below the buprice.

Rotating weekly is designed to give eac

asset enough room to breathe yet cut ofosers before they plummet too far. Iappears that works better than settinstop losses – at least when cash wa

considered one of the asset classes.



When cash was not one of the asseclasses, stop losses served to reduce thdrawdown as illustrated in Figure 23

Stopping out after a loss of 10% frohe entry price and then picking anothe

fund squeezed out slightly better CAGRand drawdown compared with casrotation.

However, stop losses in particular gedealized treatment in historica

simulations. My brokers have adviseme that my real stop loss orders in th

market may not be honored if the markedrops quickly. If they are filled, it mabe at a much lower price as the markecould plunge mid-day but recover by th

http://truthaboutetfrotation.com/wp-content/uploads/2012/10/Fig23dd-StopsBasic_TruthAboutETFRotation.jpg



close. In summary, going to cash may beasier and safer than counting on a stoposs to avert disaster.

Figure 23 – Stop Losses without Cash aan Asset

http://truthaboutetfrotation.com/wp-content/uploads/2012/10/Fig23dd-StopsBasic_TruthAboutETFRotation.jpg



Does Active

Rebalancing Help Grab

Profits?

One last attempt to grab more gainnvolves rebalancing more frequently try to catch a fund while it is up an

rotate a portion of the profits into thnext one that might advance. Figure 2ells us that monthly rebalancing offere

no reward for the extra work whil

weekly rebalancing was counterproductive.

http://truthaboutetfrotation.com/wp-content/uploads/2012/10/Fig24dd-RebalFreq_TruthAboutETFRotation.jpg



Figure 24 – Rotation with FrequenRebalancing

http://truthaboutetfrotation.com/wp-content/uploads/2012/10/Fig24dd-RebalFreq_TruthAboutETFRotation.jpg



Double-Checking the

Asset Mix

n later years, the inverse fund SH

helped contain the drawdowns and eveadd profit while the stock market fellJust to be sure using inverse funds is good idea – because it is notoriousl

difficult to make money on the short sidof the market -- I did one more set obacktesting runs shown in Figure 25.

http://truthaboutetfrotation.com/wp-content/uploads/2012/10/Fig25dd1-LongTermShort_TruthAboutETFRotation.jpg



Figure 25 – Long-term Backtest with anverse Fund

Again, including Treasuries witVUSTX and an inverse fund, RYURX

squeezed out 2% more CAGR with

http://truthaboutetfrotation.com/wp-content/uploads/2012/10/Fig25dd1-LongTermShort_TruthAboutETFRotation.jpg



ittle less drawdown. Definitely thimix won during 1998 – 2011.

Curiously, the longer term results witstocks, bonds, long treasuries, inversfunds, and cash as assets came in slightl

behind the simpler rotation without casbut all the same funds as assetsAllowing a rotation into cash when thfunds are down intuitively feels safeand allows the investor to stand aside iall other asset classes are gettinwhacked.



Which Strategies Bea

the Crash

Almost every rotation strategy produce

more profits than buy-and-hold of threference portfolio, although sometimehose profits came at the expense o

greater drawdowns.

Adding an inverse fund and a 20-yeaTreasury bond fund did the most to bee

up gains while pruning drawdownsRotating to cash offered downsidprotection without much performanchit. Stop losses did not improve on



weekly rotation with cash as an asseteither did rebalancing frequently.

To summarize, the ultimate strategy ohe bunch tested in this book relied ohese funds:

SPY or IVV for S&P 500 stocks

IWM for Russell 2000 small-ca

stocks

EEM for Emerging Market stocks

EFA for International Develope

Market stocks



AGG for Barclay’s composit

bond index

TLT for 20-year Treasury bonds

SH for inverse S&P 500

…traded in a weekly rotation among thop two funds, according to these rules:

1. Each week, calculate th

percentage total return (includindividends) for each fund.

2. Rank the funds and note



1. The top two


3. Which funds have positiv

gains over the past 140-days

3. If the account is 100% cash, splithe account 50/50 between the toptwo funds which have positiv

performance over the past 140days. If no funds have positiv performance, just stay in cash.

4. If a currently held ETF is in th

top half with positive gains, hold it


the top half, or is not showin



positive gains, then sell it.

6. With money available to inves

(usually from the sale in step 5) buy the highest performing fund noalready owned with positive gainsThe new purchase should be one o

the top two ETFs from step 2aThat is:


and the top ETF had positivgains, buy it.

2. If already in the top ETF, bu

the #2 ETF on the list, if it ha positive gains.




buy into the top 2 funds wit positive gains.

4. Re-balance annually to 50/5split of the top 2 funds wit positive gains.

…which produced the following resultn hypothetical historical simulation:

13% CAGR with -22% maximudrawdown when backtested on mutuafunds during 1998 – 2011 and 13.9%

CAGR with -16.7% maximudrawdown when backtested on ETFduring 2007 – 2011. See Figure 26.

http://truthaboutetfrotation.com/wp-content/uploads/2012/10/Fig26dd-Ultimate_TruthAboutETFRotation.jpg





Figure 26 – Hypothetical Performance othe Ultimate ETF Rotation Strategy

Over the longer term, each fund waheld, on average, roughly 100 tradindays, which is about 5 calendar months

Thus we can assume all trades get taxeat the short term rate. At 13% CAGRhis strategy may still come out ahead fo

current federal tax brackets compared tbuy-and-hold of the reference portfolio.

n a tax-free environment such as an IRAor these backtests, the rotation resultwere far ahead of buy-and-hold.

http://truthaboutetfrotation.com/wp-content/uploads/2012/10/Fig26dd-Ultimate_TruthAboutETFRotation.jpg



Figure 27 shows the year-by-yeabacktested performance of this ultimatrotation strategy. The detail of buy-and

hold returns for the diversified referencportfolio is repeated right alongside.

The mutual fund backtest results go baco 1998 while the ETF record begins a

2007. Both run to the end of 2011. Thdifferences in results between the mutuafunds and ETFs are due to the differenfund compositions. Overall, rotatiodemonstrated substantial gain

nterspersed with smaller losses ancompared favorably to buy-and-hold oa diversified portfolio.

http://truthaboutetfrotation.com/wp-content/uploads/2012/10/Fig27r-UltimateYrByYr_BnH_TruthAboutETFRotation.jpg





Figure 27 – Ultimate Rotation Strategy

Compared to Holding ReferencePortfolio

The equity curves plotted in Figure 2llustrate how a hypothetical accoun

starting with $10,000 might have fareunder rotation (the dark gray line) o

buy-and-hold (the black curve).

http://truthaboutetfrotation.com/wp-content/uploads/2012/10/Fig28-UltimateEquityCurve_Gray_TruthAboutETFRotation.png

http://truthaboutetfrotation.com/wp-content/uploads/2012/10/Fig27r-UltimateYrByYr_BnH_TruthAboutETFRotation.jpg





Figure 28 – Equity Curves fro

Backtesting Ultimate Strategy vs. Buyand-Hold

Rotation won out big-time in the end, bunotice that the first five years were oss-up where buy-and-hold was ofte

ahead. In 2006 and 2010, the holdin

he reference portfolio produced lesvolatility. Keep in mind that threference portfolio was diversifie

across several asset classes and makes strong investment in itself.

From 2004 – 2009, the rotation strateg

http://truthaboutetfrotation.com/wp-content/uploads/2012/10/Fig28-UltimateEquityCurve_Gray_TruthAboutETFRotation.png





Resources

eb Sites

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all tables from this book

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click here to visit the special page foowners of this book .

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beathecrash.com – website for thiwhole series of books

divergence-alerts.com – members cafollow along with my ETF rotatiostrategy and also get a list of the MACD

divergences on US stocks, ETFs, anfutures.

http://www.divergence-alerts.com/

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glossary

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the Beat The Crash

http://www.amazon.com/Beat-The-Crash-Diversified-Portfolio/dp/B00B4HLZU2/ref=sr_1_3?ie=UTF8&qid=1362694764&sr=8-3&keywords=diversified+portfolio

http://backtestingblog.com/category/glossary/

http://www.backtestingblog.com/



series by defining a

baseline for comparison

of investment strategies.

A diversified portfolio is

described as well as its

hypothetical historica

performance. Alsocovered are metrics for

comparing investmenstrategies.



Beat The Crash - Truth About ETF

Rotation, Vol 1 Disc 2

Delves into how to do ETF Rotation an

he historical simulated performance orotating the diversified portfolintroduced in Disc 1.

Software

Rotation Spreadsheet - an open-sourcspreadsheet that can help you find thop ETFs by calculating the 140-da

otal percentage gains. It also computestop losses and attempts to size eacrade. Available at this book’companion website

ruthaboutetfrotation.com.


http://www.amazon.com/Beat-The-Crash-Truth-Rotation/dp/B00BCO042C/ref=sr_1_4?ie=UTF8&qid=1362694608&sr=8-4&keywords=etf+rotation



Related Reading

My current reading list is posted ahttp://backtestingblog.com/order/books/

http://backtestingblog.com/order/books/



Acknowledgements

Thank you to John Chernicky for hinsightful reviews of this book. Al

errors are mine.

Scott Ajax spotted errors in the originadrawdown calculations in my portfoli

esting software. I am thankful that hpersisted in calling them to my attentiountil they were fixed. I takresponsibility for all remaining bugs an

miscalculations.

am grateful to Aric Egmont at Fidelit

nvestments for motivating me to giv



sector rotation a second look, and fopublishing my article on the topic.

Thank you to my family and friends fopatient understanding and encouragemenwhile I research the market and write.

Hat tip to Pearl Sofaer for publishing hebook which inspired me to write mine.

Thank you, Dear Reader, for youattention. The knowledge that you wil

be reading this book motivated me to pun my best effort.



Kindly consider leaving

a REVIEW on Amazon ,

please. Thank you!

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Documents

Truth About ETF Rotation - Fund - Patterson, Jackie Ann