A practical investment strategy using momentum and trend following

There are many investment strategies out there. What we are going to explore today is to use asset classes, momentum and trend-following using ETFs ( exchange traded funds)to generate above average returns.

 The first question is what asset classes to use. There are many ways one can choose asset classes. A very good article to read is “The Ultimate Buy and Hold Strategy“. Reading this article will show us what asset classes matter. I would add long-term bonds, commodities and gold to the asset classes mentioned in the strategy.

So the important asset classes, in my opinion are:

  1. Stocks
  2. Bonds
  3. Real estate
  4. Commodities
  5. Cash

To divide these further:

  1. US large cap
  2. US small cap
  3. International
  4. Emerging Markets
  5. Short term bonds
  6. Intermediate term bonds
  7. Long term bonds
  8. REITs( Real estate investment trusts)
  9. Commodities
  10. Gold
  11. Cash or T Bills

We can further divide this to include value stocks, individual commodities, etc, but let us keep it simple.

Let us find ETFs for these asset classes:

The second step is to calculate the 1 month, 3 month, 6 month and 12 month total return for the above ETFs and calculate the average return. This is the momentum ranking.you can find this in the Morning Star website for free.

For example if you calculate this on the 28/11/2012, the results are as follows( from the best performance to the worst performance):

ETF 1 month 3 month 6 month 12 month Sum Average
Russell 1000 -1.78 3.05 1.79 14.75 17.81 4.4525
EAFE 1.06 7.14 2.07 6.13 16.4 4.1
Russell 2000 -2.24 3.9 0.85 11.79 14.3 3.575
REITs -0.83 -2.78 -0.12 14.57 10.84 2.71
Long term bond -0.41 -3.14 6.15 4.4 7 1.75
Emerging -0.54 5 -1.28 3.56 6.74 1.685
Gold -2.94 6.61 3.06 -0.3 6.43 1.6075
Int. term bond -0.36 -0.31 1.53 3.83 4.69 1.1725
Short term bond -0.07 0.01 0.14 0.35 0.43 0.1075
Cash/T Bills 0.02 0.02 -0.02 -0.02 0 0
Commodities -3.91 1.14 -2.99 -0.58 -6.34 -1.585

The third step is to see whether these asset classes are above their 200 day moving average or not( on 28/11/2012). This is the trend following bit of the strategy.

  • Vanguard Russell 1000 index: Above 200 day moving average
  • Vanguard Russell 2000 index: Above 200 day moving average
  • Vanguard MSCI EAFE index: Below 200 day moving average
  • Vanguard REIT index: Below 200 day moving average
  • Vanguard long-term government bond index ETF: Above 200 day moving average
  • Vanguard intermediate term government bond index ETF: Above 200 day moving average
  • Vanguard short-term government bond index ETF: Above 200 day moving average
  • Vanguard MSCI emerging markets ETF: Below 200 day moving average
  • SPDR Gold shares ETF: Below 200 day moving average
  • Powershares Commodity ETF: Equal to 200 day moving average
  • T Bills: Not calculated

The investing system

BUY RULE

The system invests in the top X ETFs if the ETF is trading above its 200 day moving average.

If not, that part is invested in T Bills or short/intermediate term bonds.

If you want more return and are willing to take some extra risk, invest in short/ intermediate term bonds, otherwise go to cash which is the safest and least risky.

For Top 1, the system is 100% invested in the top ranked sector.

For Top 2, the system is 50% invested in the top two sectors.

For Top 3, the system is 33% invested in the top three sectors and so on.
SELL RULE

Since the system is a simple ranking, the top X sectors are held and if a sector falls out of the top X sectors it is sold at the monthly rebalance and replaced with the sector in the top X.

1. All entry and exit prices are on the day of the signal at the close. The model is only updated once a month on the last day of the month. Price fluctuations during the rest of the month are ignored.
2. All data series are total return series including dividends, updated monthly.
3. Taxes, commissions, and slippage are excluded

Let us see what we will do if we use this system. I decide to invest in short/intermediate term bonds if a ETF is below 200 day moving average and decide to invest in the top 3 ETFs.

The top three ETFs are:

  • Russell 1000: above 200 day moving average: Therefore invest
  • EAFE: below 200 day moving average: Therefore this part will go to cash or short/intermediate term bonds
  • Russell 2000: above 200 day moving average: Therefore invest.

So if I invest, say 100,000 dollars:

  • 33% in Russell 1000
  • 33% in Russell 2000
  • 33% in cash or short/intermediate term bonds. So since I am going to invest in short/intermediate term bonds I will put 16.5%(50% of 33%) in short term bonds and 16.5% in intermediate term bonds.
  • Then wait for 1 month to make changes and rebalance.

This can be done in many ways using a lot of different parameters and asset classes. Some good resources are as follows:

I hope this was useful.

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