In this thread I'm going to document the development of an ETF-based "global tactical asset allocation" system. What are the goals of this system? It's meant to take the main role of allocating a long-term portfolio. Hopefully we will be able to increase returns while simultaneously decreasing drawdowns, time spent underwater, and volatility.
Since we're simply going to be trading ETFs, leveraging up (almost certainly a good idea for younger people like me, still in the early stages of retirement saving and with a very long horizon) is going to be easy. Since we're going to be controlling drawdowns, it will also be easier to trade from a psychological/risk of ruin perspective.
The benchmarks:
I'm going to be using three benchmark strategies: 100% SPY, 60% SPY / 40% IEF, and a better-diversified approach with 20% SPY / 15% EFA / 15% EEM/ 20% IEF / 10% LQD / 10% VNQ / 10% DBC.
The data is from 2002 to roughly june 2010 for the development, then the rest as an out of sample test.
The ETFs I'm going to be using are the following:
AMJ - JPMorgan Chase Capital XVI JP Morgan Alerian MLP ETN
DBA - PowerShares DB Agriculture Fund
DBB - Powershares DB Base Metals Fund
DBC - PowerShares DB Com Indx Trckng Fund
DBV - Powershares DB G10 Currency Harvest Fund
EEM - iShares MSCI Emerging Markets Indx
EFA - iShares MSCI EAFE Index Fund
FXE - CurrencyShares Euro Trust
HYG - iShares iBoxx $ High Yid Corp Bond
IEF - iShares Barclays 7-10 Year Trasry Bnd Fd
LQD - iShares IBoxx $ Invest Grade Corp Bd Fd
RWX - SPDR DJ International Real Estate ETF
SH - ProShares Short S&P500 [Yes, I know you're not supposed to use it like this]
SHY - iShares Barclays 1-3 Year Treasry Bnd Fd
SPY - SPDR S&P 500 ETF
TLT - iShares Barclays 20+ Yr Treas.Bond
VBR - Vanguard Small-Cap Value ETF
VNQ - Vanguard REIT ETF
XRE - iShares S&P TSX Capped REIT Index Fund
Some relevant readings that I highly recommend:
Amazon.com: The Ivy Portfolio: How to Invest Like the Top Endowments and Avoid Bear Markets (9780470284896): Mebane T. Faber, Eric W. Richardson: Books (
Rotation Concepts CSS Analytics (
Rotation Part Deux (Two) CSS Analytics (
Relative Strength Strategies for Investing by Mebane T. Faber :: SSRN (
The basic concept is trend-following. We're going to be ranking each class based on its relative momentum, and investing in the top ones. We're going to be testing permutations based on the lookback period, smoothing the ranking, the number of securities to invest in, how to allocate between our holdings, absolute momentum cutoffs, etc. Hopefully some new ideas come up through this thread that can lead to additional improvements.
I am going to ignore the effects of taxes and transaction costs as these vary from investor to investor; transaction costs are not very important for this approach but taxes can be a very significant factor, so tread carefully.
UPDATE: a step-by-step guide including the latest improvements
Pick your universe of assets. A good starting point is the list above; you may want to change it to suit your needs and preferences.
Follow the steps below to update the allocation every Friday.
Take the 30 trading day average price, and divide it by the price 120 trading days ago. This is the smoothed ROC (or momentum).
Rank all the assets by the smoothed ROC, and save the ranks.
Divide the last smoothed ROC by the smoothed ROC value 20 days ago. This is the acceleration.
Rank all the assets by their acceleration, and save the ranks.
Add the mometum ranks multiplied by two to the acceleration ranks of each asset, and rank them again by their value of combined ranks.*
If the asset is already in your portfolio, give it a bonus of +2 to the combined ranking.*
Select the top x (I recommend 5) assets by this ranking.
Test if their smoothed ROC is above the hurdle rate (I recommend 3%). If the asset is already in the portfolio, use a lower hurdle rate (lower it by 0.25%). If the hurdle isn't cleared, discard the asset.
Finally, using the assets that have cleared the hurdle, calculate their …