As rotation strategies are becoming more and more popular with quantitative traders, creative traders are finding different ways to add value to their strategies. The constantly increasing number of ETFs available for these types of strategies is allowing traders the ability to really focus their capital with extreme precision.
An article that was published by Dorsey Wright Money Management did a nice job of illustrating one such adjustment that focused trading on the momentum stocks in each sector that was considered. That slight tweak ended up adding 2-3% in average annual return to the simple rotation strategy that they were backtesting.
The article gives us just one example of how focusing our capital on specific areas at different times can greatly increase the returns of rotational strategies without a severe impact on the overall risk. It would be interesting to see if there are any strategies that have found success with combining multiple adjustments like this one.
The Basic Strategy
The basic strategy that the article broke down held either 3 or 5 of the SPDR Sector ETFs at any given time. The portfolio was rebalanced each month based on either 3 or 6 months returns. That gave them four different version of the same rotation strategy:
- Holidng 3 ETFs with a 3-month lookback period
- Holding 3 ETFs with a 3-month lookback period
- Holding 5 ETFs with a 3-month lookback period
- Holding 5 ETFs with a 6-month lookback period
Each of these strategies produced very similar results. The highest risk adjusted return was produced by the one that held 3 ETFs with a 3-month lookback period. That strategy produced an average annual return of 11.3%.
Improving The Strategy
The way that the article improved the strategy was to give it the option to trade the standard SPDR ETF or the company’s momentum version of that ETF. This decision was simply based on whichever had the best return over the strategy’s lookback period.
The article points out that there are times when the market will favor large-cap stocks, which means the standard ETFs will be more favorable. There are also times when the market favors smaller-cap momentum stocks, which would favor the momentum based index.
Giving the strategy the option to choose between the standard ETF or the momentum index increased the average annual profit for the 3 stock, 3-month lookback period strategy to 13.5%. Each of the other three versions saw similar jumps. While there were also jumps in standard deviation, the increased profits were substantial enough to offset those increases.