Last Updated on August 26, 2021 by Oddmund Groette
Some days ago we published an article that rotates between SPY, TLT, and EEM based on monthly momentum. Today we look at a similar ETF sector momentum/rotation strategy but we exclude EEM: we only look at SPY (S&P 500) and TLT (20 year Treasury bond).
TLT works as a safe haven when the stock market is weak. Below you find the logic and code for this simple SPY and TLT momentum/rotation strategy. The drawdown is low but the total return is better than “buy and hold”.
What is momentum and how has it performed?
Momentum is a well-known strategy that has performed well for many decades. It doesn’t work on long timeframes, but best on semi-long timeframes from 1 to 12 months.
For example, one strategy that has performed well is to buy the stocks that have performed the best over the last six months. At the end of every month, you rank the best stocks and buy the best x stocks and hold them for one month. At the end of next month, you rank again. Rinse and repeat every month going forward.
The only drawbacks with momentum strategies are big drawdowns and survivorship bias:
What is sector rotation?
Sector rotation is changing assets tactically when you sell one asset and buy another one. Switching between SPY and TLT is a perfect example of sector rotation. Frequently, sector rotation is based on momentum strategies.
Trends come and go. However, it’s difficult to predict which asset classes perform the best in the future. Hence, many define strict rule-based trading purely based on quantitative rules, exactly what this website is all about. Below you find our test on monthly rebalancing between SPY and TLT based on the best performance the prior month.
Why should sector rotation between SPY and TLT work?
S&P 500 and Treasury bonds have been used for a long time for tactical asset allocation based on momentum and rotation. Why is that?
The most likely explanation is this:
Treasury bonds are a safe haven. When the future is uncertain many investors seek to allocate more to risk-free assets like Treasuries. The relationship tends to last a few months. This is why this type of sector rotation is so popular.
Is sector rotation and momentum a hedge against tail risk?
Nassim Taleb became famous for his thoughts about randomness and tail risk. Because tail risk increases chances of bankruptcy and behavioral mistakes, both traders and investors should have tail risk in the back of their heads all the time:
As it turns out, please see the chart below, the rotation between the S&P 500 and Treasury bonds has produced slightly better returns than holding the S&P 500, but at the same time had substantially less drawdowns. Thus, we can argue this strategy is a hedge against tail-risk, but it’s, of course, no guarantee this will repeat in the future.
Testing momentum/rotation between SPY (S&P 500) and TLT (Treasury bonds):
Let’s test how this strategy performs when rotating between SPY and TLT:
- It’s based on monthly quotes in the ETFs SPY and TLT.
- Every month rank both based on last month’s performance/momentum.
- Go long the one with the best performance the prior month.
- Hold for one month and repeat (or continue being long the same instrument).
This is all there is to it. Obviously, this strategy is best performed in a tax-deferred account, but without slippage and taxes the equity curves look like this:
The strategy outperforms buy and hold for both ETFs, but perhaps more importantly has a lower drawdown. Th chart above is in percentages, not compounded.
Is this strategy likely to perform just as well in the future? I don’t know. Interest rates have been going down and are now close to zero. But the beauty of this strategy is that it has performed well both during the financial crisis in 2008/09 and currently in 2020 during Covid-19 (at least so far).
The Amibroker code for a rotation/momentum strategy
If you invested 100 000 in June 2003 and reinvested all profits in the next trade (compounding) the chart looks like this in Amibroker:
Entries and exits are done at the close each month and no slippage and commissions are included.
The above strategy can easily be coded. We have compiled code for 60+ other free strategies on this website (the code for this rotation/momentum strategy is included, of course). Read here for more:
TLT and long-term Treasuries work as a safe haven when uncertainty picks up. This is the reason why our SPY and TLT rotation/momentum strategy performs very well.
Is it likely to continue working in the future? That’s of course hard to say, but we believe so, even though the rates are at an all-time low.
Disclosure: We are not financial advisors. Please do your own due diligence and investment research or consult a financial professional. All articles are our opinion – they are not suggestions to buy or sell any securities.