Combining Rotation and Timing Systems

This is probably the #1 question I receive on email, usually in two forms:

q #1 – “Meb, have you considered combining the two timing systems?  Use the rotation system across the 5 asset classes from your book, but sell an asset and move to cash when it declines below its X moving average?”

or

q #2 – “Meb, have you considered combining the two timing systems?  Use a rotation system but move to cash for the whole portfolio when it declines below its X moving average?”

The questions sound similar but are slightly different.  I don’t think #1 will make any difference in performance (since I wrote this post I tested it and confirmed that it makes no difference).  For the vast majority of the time the asset is already above the moving average until the end when it drops, and the moving average usually doesn’t pick that up.

Q#2 is much more interesting to me.  However, you can only test this WITHIN an asset class.  Below we take a look at US Stocks.  (I see no reason this wouldn’t work in other asset groups like commodities, bonds, currencies, and foreign stocks.)

I used the Fido Sector funds from 1988-5/2009.

I took the top fund, updated monthly, based on the average rolling 3/6/12 month performance.

I then took the top 3 funds, equal weighted and updated monthly, based on the average rolling 3/6/12 month performance.

I then took the same portfolios, but moved them to cash when the S&P500 declined below its long term moving average (10 month simple).

Results are below.  Note how the rotation system generates about 5-6% outperformance per year.  The volatility is high (likely due to the upside volatility), and drawdowns are similar to buy and hold.  Using the timing system to hedge the portfolios resulted in declines in volatility (around 20%) and most importantly, a reduction in drawdown from 53% to around 27%.  Sharpe #s are misleading due to the high returns. . .

One could simply buy the ETFs or mutual funds when above the SMA then hedge or sell and move to cash when below.  Depending on the fund/broker, there could be  $$ transactions costs involved (especially if the account was small).   One could also just move into a rotation fund when above, then sell when below.  (Note: I haven’t looked at ANY of these funds below so no recs either way.  Most of them FAIL for various reasons).  If I am missing any, add them in the comments and I’ll edit.

PS Anyone wanna take the over under on how long till Barclay’s Blackrock offers momentum ETFs?  I say by the end of 2009.

Broad rotation funds (benchmark, 60/40 or diversified benchmark)

FUNDX Tactical Upgrader, (TACTX).

DWA Balanced (DWAFX).

US Stock rotation funds (benchmark, S&P500)

FUNDX Upgrader Fund (FUNDX)

Rydex Sector Rotation Fund (RYSRX)

DWA Technical Leaders (PDP)

VL Industry Rotation (PYH)

VL Timeliness (PIV)

Claymore/Zack’s Sector Rotation (XRO)

Foreign Stock rotation funds (benchmark, MSCI EAFE)

Rydex International Rotation Fund (RYFHX)

Claymore/Zack’s Country Rotation (CRO)

In registration:

AQR International Momentum Fund

AQR Momentum Fund

AQR Small Cap Momentum Fund

IndexIQ Momentum Leaders All Cap Fund

XTF COUNTRY ROTATION ETF PORTFOLIO

XTF SECTOR ROTATION ETF PORTFOLIO

Log and non-log charts of the equity curves below.