Bond Rotation Strategy

Monthly Momentum in S&P 500 and Treasury Bonds (Bond Rotation Strategy in SPY and TLT)

TLT vs SPY – Bond Rotation Strategy. Some days ago we published an ETF rotation strategy 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: A SPY and TLT strategy (S&P 500 and 20 years Treasury bond).

The SPY and TLT rotation trading strategy might work well because TLT often 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 are frequently mentioned as a tactical asset allocation strategy based on momentum and rotation. Why is that?

The most likely explanation is this:

Treasury bonds are often a safe haven. When the future is uncertain, many investors seek to allocate more to assets like Treasuries. The relationship tends to last a few months. This is why this type of sector rotation is so popular.

monthly-momentum

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 the chances of bankruptcy and behavioral mistakes, both traders and investors should have tail risk in the back of their heads all the time:

However, TLT is not a hedge against tail risk. The strategy worked well before 2022, but ran into big problems in 2022 when both SPY and TLT fell sharply. Let’s backtest the strategy

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. We make the following trading rules:

Trading Rules

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The rules are simple. Obviously, this strategy is best performed in a tax-deferred account, but without slippage and taxes, the equity curves look like this from 2003 until today:

Rotation strategy SPY vs TLT
Rotation strategy SPY vs TLT

Despite the drawbacks in 2022, the CAGR is still a decent 9.2% with dividends reinvested. Max drawdown was a “minuscule” 22% up until the bond debacle in 2022, when it came in at 41% (!). This shows that the biggest drawdown is still yet to come when you backtest.

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 (but they are modest).

The above strategy can easily be coded. We have lots of code and ideas if you become a member.

FAQ:

Why might the SPY and TLT rotation strategy work well?

The SPY and TLT rotation strategy involves tactically switching between SPY (S&P 500) and TLT (20 years Treasury bond) based on monthly momentum. TLT often functions as a safe haven (but as in 2022 shows – not always) when the stock market is weak. The strategic rotation between SPY and TLT is based on sector rotation principles and momentum strategies, taking advantage of the perceived safety of Treasury bonds during uncertain times.

What is momentum, and how has it performed in trading?

Momentum is a trading strategy that focuses on assets’ performance over specific timeframes. It has historically performed well on semi-long timeframes, typically ranging from 1 to 12 months. Sector rotation involves tactically changing assets, such as selling one asset (e.g., SPY) and buying another (e.g., TLT). The SPY and TLT strategy exemplify sector rotation based on quantitative rules and monthly rebalancing.

How is the SPY and TLT rotation strategy tested, and what are the trading rules?

The strategy involves monthly switching between SPY and TLT based on last month’s performance. The rules include ranking both ETFs based on performance, going long on the one with the best prior-month performance, and holding for one month before repeating the process.

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