Thursday, September 23, 2010

Diversification, Momentum and Sidestepping the 2008 Panic

While most trading systems I know – including my own – struggled to eke out a profit during the 2008 financial crisis, it is certainly worth investigating which sort of strategies and approaches might have allowed investors not just to sidestep the 2008 panic, but to profit from it.

Using some functionality recently released by ETFreplay.com, I assembled a portfolio of ten ETFs from multiple asset classes and tested that portfolio in ETFreplay’s Portfolio Moving Average backtesting tool, which evaluates each ETFs relative to a moving average and goes long if the ETF is above the specified moving average (MA) and is in cash when the ETF is below the MA. I experimented with a variety of moving averages up to 12 months and from time periods going back to 2003 (recall that most ETFs do not have an extensive history) and came up with some interesting results.

The chart below shows the Multi Asset Class ETF portfolio since the beginning of 2007, using a 6 month MA (results were better using a 7-10 month moving average) as the evaluation period. Note that even during these tumultuous times, the long/cash strategy over the ten ETFs suffered a maximum drawdown of only 7%, had volatility that was only about 1/3 as much as the S&P 500 index (SPY) and managed a cumulative return of over 42% while stocks in general were putting up double-digit losses.

Of course my point is not that the strategy described below is the holy grail when it comes to risk-adjusted returns, but that investors should take advantage of tools like the one mentioned above to tinker with ideas and tactics in order to refine existing strategies or perhaps devise new ones.

ETFs offer incredible diversification across all asset classes and in today’s markets, every little extra edge helps.

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[source: ETFreplay.com]

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