This article presents an ETF rotation strategy. Sector rotation is popular and this is not without merit. The idea is to be in the sector that shows the best recent momentum. Today we present an ETF momentum rotation trading strategy based on monthly data in EEM, SPY, and TLT.
ETF momentum strategies are one of the factors that have proven to work for many decades. In this short article, we give an example of a very easy and simple ETF rotation strategy among SPY (S&P 500), TLT (Treasury bonds), and EEM (MSCI Emerging Markets) that has worked pretty well over the last two decades. It has beaten “buy and hold” with lower drawdowns.
Momentum and sector rotation in ETFs (TLT, SPY, and EEM)
SPY is an ETF that tracks the S&P 500, TLT tracks the 20-year Treasury bonds, while EEM tracks the MSCI Emerging Markets Index.
Why did we choose these three ETFs?
SPY was chosen because it’s the most important stock index on the planet. The S&P 500 is, by far, the most followed stock index on the planet.
The EEM was chosen because it’s one of the markets that correlate less with the SPY. Emerging markets often go their own ways compared to the stock markets of the Western world.
Lastly, TLT was included because it’s a “safe haven”. When the stock markets turn ugly, many seek refuge in the safe harbor of US long-term Treasury bonds.
That’s the theory. Does it hold up in practice?
Our sector rotation strategy in TLT, SPY, and EEM shows solid results
Yes, the theory held up pretty well in the backtest we did. This is what we did (trading rules and settings):
- It’s based on monthly quotes in the ETFs SPY, EEM, and TLT.
- Every month rank them based on last month’s performance and go long the best performing ETF.
- Hold for one month and repeat (or continue being long the same instrument).
This is all there is to it. It can hardly get any simpler than that. This is a strategy that requires 10 minutes of work per month!
Obviously, this strategy is best performed in a tax-deferred account because of the frequent rotation among the ETFs.
The best strategies can be found in our….
Backtested trading strategies
Without slippage and taxes the equity curves look like this in Excel:
The strategy outperforms all the other ETF’s, despite underperforming SPY in both 2018 and 2019. The chart above is in percent, ie not compounded equity.
How did the strategy perform lately during the Covid-19?
In January 2020 it was long EEM for a 4.14% loss. For February, March, and April 2020 the rotation strategy was long TLT. May and June were long SPY. The total return for 2020 is 17.1%.
The strategy works reasonably well for quarterly rebalancing also, but not very well for anything shorter than monthly.
Rotation code for Amibroker
If you invested 100 000 on the first day of 2003, the strategy has compounded pretty well:
The chart above shows 100 000 and reinvested (compounded) monthly.
The entry and exit are done at the close each month and commissions and slippage are not included. The CAGR is a pretty respective 14% and the max drawdown is 22% – both trading performance metrics are substantially better than for SPY alone.
ETF rotation strategy – conclusion:
The ETF rotation strategy we presented in this article has performed very well. The question is: will it continue to do so? We believe so. This has worked for many decades and looks likely to continue, but there are no guarantees, of course.