With a simple strategy, drawdown for US equities are utilised to take advantage of the subsequent recovery. The STRATEGY SEEKS TO ROTATE FROM DEFENSIVE INTO OFFENSIVE 53 EQUITY SEGMENTS FOR A LIMITED TIME HORIZON, OR ALTERNATIVELY, determines whether or not to invest in the US stock market at all. In the last almost four years, the performance of this strategy was substantial.
Drawdown: when stock markets take a dive or even crash, often the following recovery of stock prices is all the more impressive. A strategy that identifies these recoveries early on can be a very profitable tool. With a study that goes back well into the 1980s, time periods after drawdowns that are associated with high daily returns are identified. At the same time, the risk during these time periods is lower than it is over the remaining trading days. An investor who wants to be invested in stock markets only when risk is relatively low can benefit from these characteristics. For those limited time frames, an ETF on US equities is held. Investors who are permanently invested in the US stock market utilise the strategy to jump from defensive into more offensive equity segments for a short time, or even make use of leveraged ETFs.
The one year high of the S&P 500 Index is measured daily. We have a signal when the index falls at least five per cent below this high and returns above the 95 per cent hurdle again, all measured on daily close prices. On the following trading day’s close, the US equity market ETF is bought or the investor rotates into the more offensive US equity ETF, respectively. The new position is held for one month, before rotating back into the more defensive ETF or respectively exiting the US equity market, both on the following trading day’s close. In case a new signal is established during the holding period, another month for holding the position is added.
We do not employ a stop loss or other explicit risk management tools. The short period of just one month can be understood as an implicit risk management measure. The stock market already had a drawdown and is now in an upward trend. The probability of another significant drawdown within that month is quite low.
The lower risk can be found in the historical results. Between 2012 and October 2015, seven signals to enter the US equity market were established. All seven trades display positive returns. Looking back further into the past, the ratio between winning and losing trades is around 75 per cent to 25 per cent.
We chose a broad US equity market ETF (MSCI USA Source ETF) be used for rotation, switching from one ETF into another one. In general, the investor holds a defensive US equity ETF. We do not precisely define what may fall under defensive or offensive but instead use a common classification. Low volatility, broad diversification, or large and well-known stock baskets may belong to the defensive category.
For the following examples, the broad US equity market (MSCI USA Source ETF, mentioned above) is employed as the defensive position. The ETF is held until a signal is established. At next days’ close, rotation into the more offensive US equity ETF for one month follows.
A first example for an offensive position is the DB X-Trackers Russell 2000 ETF which tracks US small cap stocks. In the last almost four years, this rotation would have delivered +115 per cent or 22 per cent annually. It is significantly above both single ETF returns over the period. In comparison to holding the defensive ETF over the entire time, volatility only increases marginally. Applying the Comstage NASDAQ-100 ETF as the offensive position reveals similarly good risk and return figures. At the beginning of the article, we sought to identify time periods during which daily returns are higher than usual. They are roughly twice or even three times as high as the daily returns over the complete period. In addition, all seven trades exhibit positive returns, and the historical ratio of 75 per cent winners versus 25 per cent losing trades is very high. These are favorable characteristics for employing a leveraged ETF as the offensive position. The Amundi MSCI USA Leveraged ETF might serve this purpose. The annual return over the three year period now increases to 28 per cent. The Sharpe Ratio is 1.7. Remarkably, the Maximum Drawdown only increases slightly compared to holding the defensive ETF over the whole period.All mentioned ETFs are denominated in Euro. As a consequence, the currency component contributes to the performance. By now, several ETFs are available that hedge the US dollar and therefore take currency risk out of the equation.
The drawdown and recovery periods of the S&P 500 in the last almost four years reveal valuable characteristics. The insights gained can be applied for market timing or for rotation within the equity space. The strategy described here is very simple, implementing rudimentary selected
Significantly better return and risk figures of the rotation strategy compared to constantly holding the defensive ETF are mainly driven by identifying the time frames to rotate from defensive into offensive equity segments. A rough definition of which US equity ETF to classify as defensive or offensive is sufficient for significant risk-adjusted outperformance of the rotation strategy.
Admittedly, a positive stock market environment as seen in the last four years – with the exception of summer 2015 – is supportive for this strategy. The 20 years before brought all ups and downs. Even over this longer term, the strategy’s back-test is convincing, especially if implemented for market timing only. Together, the strategy and insights gained might be very valuable for the next US equity market drawdown.
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