Sep 14, 2016
Relative Strength
Why does your Relative Strength ranking of ETFs, work better than ranking them using the Sharpe Ratio?
The ETFreplay Relative Strength ranking methodology has the Sharpe Ratio concept at its core but it also reflects some more modern financial modelling methodologies.
So the Sharpe Ratio has volatility in the denominator. The thing about this is that the Sharpe Ratio effectively overrates very low volatility ETFs. In reality, investors value returns more than they do extreme low volatility. For example, a 12% return with 8% volatility is viewed much more positively than an 8% return with 4% volatility. That move from 8% down to 4% is not nearly as meaningful as the return differential. What investors really want is a solid return with acceptable volatility. Investors can tolerate some level of drawdown with a long-term focus -- just not large drawdowns.
Another thing we did was enable the user to use 2 timeframes for return. The reason is that it is well-accepted that a model can have up to 3 factors as the factors can help each other out. More than 3 factors starts to run into data-mining, which is something we need to be careful of.
Sometimes 1 factor which backtests well over longer time periods can have a rough patch. Another factor can help mitigate the problems and by using 2 return periods, we are not overly reliant on a single return factor.
Hope that helps and let us know if you have any other questions or comments.
See also our FAQ's for common questions
Sep 02, 2016
Ratio
There are lots of ways to skin a cat of course. Here is a look at results of using a simple total return ratio between Emerging Markets (VWO) and an iShares Treasury ETF (IEF):
Jun 08, 2016
Channel
We recently added Total Return percentile channels to our range of backtesting tools.
The primary focus of ETFreplay has always been on relative strength analysis and we have tended to see moving averages as serving largely as an easy to understand introduction to backtesting in general.
Like basic MAs, channels are a trend following approach that use only an ETFs own past return history. i.e. they are not relative.
However, unlike MAs, channels are defined by two measures (highs and lows) rather than just one, which intuitively makes sense as an uptrend is a series of higher lows and higher highs. This also means that channels automatically adjust to volatility.
i.e. in a wide swinging trading range the channel boundaries will be far apart, whereas when the market winds down into tight range the channel will be narrow.
Standard channels are simply the highest and lowest values over the prior x days, weeks or months and the use of channel breakouts in trend following is long established. However, for investors such wide channels can mean:
- Slow responsiveness. Trade frequency is extremely low because it takes a lot to enter a position and a very large change to trigger an exit.
- Whipsaw losses, when they occur, are painfully large.
To ameliorate these problems, the backtests allow percentiles of the channel to be employed (the defaults being the 75th percentile for buys and 25th percentile for sells). Doing so means that positions are entered / exited sooner, but the channel still remains wide enough to mitigate against frequent quick whipsaws.
See:
Single ETF channel backtest
Portfolio channel backtest (subscribers)
Apr 12, 2016
Over the last eighteen months US equity low volatility and relative strength strategies have performed comparatively well, whereas moving average and international portfolios have generally struggled. The reality is that, regardless of whichever investment approach is adopted, there will be periods of both outperformance and underperformance. It was ever thus.
Good returns are fairly easy to handle; unless they lead to hubris, they largely take care of themselves. But there are no certainties in investing, only probabilities.
Nothing works all the time. Even when the odds are strongly in your favor, the trade / position won’t always work out. Probabilities play out in the long-run. In the short-term, anything can happen. Accept it.
There will be periods of underperformance. When this happens it will be tempting to switch to a different approach that’s recently performed better. However, constantly searching for the 'answer' and bouncing between strategies is a great way to fail to capture the long term returns of any approach.
i.e. Chucking in the towel on a buy-and-hold portfolio in 2009 and switching to a trend following approach. Then changing strategy once again in 2015 after that took some whipsaw losses.
Having realistic expectations from the start makes it considerably more likely that you will have the necessary perseverance to stick with your chosen strategy. This is where analyzing backtests, delving deep into the results, seeing that there have been adverse periods in the past, can be highly beneficial.
Pursuing any single investment approach requires mental fortitude. Buy-and-hold investors need to be able to stomach the deep drawdowns that their portfolios will suffer in bear markets. Those investing tactically require the temperament to handle the frustration of inevitable whipsaws.
Diversifying at the strategy level (a la core-satellite), however, can provide an emotional hedge for those times when the market environment is particularly unfavorable to one approach or the other. It obviously also means not having to trust one’s objectives to the performance of a solitary model.
Regardless of the approach, it’s the process, rather than short-term results, that must be kept uppermost. It’s by sticking with the process that objectives are most likely to be achieved over the long run.
Some resources that might be useful:
A Wealth of Common Sense: From Great to Good
A Wealth of Common Sense: The Psychology of Sitting in Cash
Morgan Housel: It Was a Good Bet
Meb Faber: Why Are You Outperforming? Why Are You Underperforming?
Bason Asset Management: Diversification Sucks
Dec 22, 2015
Backtest
In one of the best poker books ever written The Theory Of Poker, the author makes a point quite relevant to investing. He writes,
“Beginning poker players sometimes ask, ‘What do you do in this particular situation?’”
The problem is that it is simply the wrong question and indicates overly-simplistic mode of thought. The right question is:
“What do you consider in this particular situation before determining what to do?”
Likewise, the term ‘backtest’ is sometimes viewed critically by those who are beginners. Some make simplistic assumption that just by applying a longer timeframe to a given backtest then validates a strategy and that therefore they can just follow a simple model and don’t have to burden themselves anymore with any critical thinking.
But ETF backtesting isn’t anything more (or less) than information, and in the investment business, information is research. Research is what leads you to make informed decisions. Often times you run backtests that seem to conflict with each other in terms of what to do at a given point in time. A quarterly updating backtest with a 12-month lookback might have good results and indicates to hold on until Dec 31 while a monthly backtest with a 3-month lookback might be indicating a switch is called for immediately. Some argue that whichever one has a higher return over the longest timeframe available must be correct. But frankly, your strategy backtested to the year 1900 might not be nearly as relevant as you think (see Intro to Regime Change ETF Backtesting). It may even be an awful strategy for the present-day environment.
At the end of the day it is sometimes going to be a judgment call based on the weight of the evidence and the conclusions you reach based on your overall research/information.
No matter whether you stand pat and do nothing or make some trades due to perceived increased risk, you might end up wrong in the short-run. This is why you focus on the decision-making process and not short-term results because any single decision can lead to a poor result. But performance over time is the culmination of many decisions.
Some might say to this…. ‘well I don’t want to play’ and I do have the choice to ‘just buy index funds.’ But ask anyone maintaining a buy and hold global portfolio how those ‘just buy index funds’ portfolios have done? They are loaded in international stocks and emerging markets and have portions allocated to gold and other commodities. Have you seen how poorly these segments have done? Moreover, do you think the S&P 500 is immune to similar bouts of very poor relative performance? Think again.
The point is that any judgment you make can be right or wrong, so don’t think anyone is removed from the process just because they buy index funds. They aren’t. You didn’t see buy & hold investors do much marketing in 2001-02 during a bear market. Nor in 2008-09. Buy and hold global advisors of today can’t market their returns because they have losses, not returns.
Summary: Focus on what to ‘consider’ and then make an informed decision. Good investors know how to control their drawdowns while still exposing themselves on the long side as a general framework. Backtesting is very much a part of this broader decision-making process because be it buy hold portfolio allocation backtesting or tactical backtesting, backtesting is simply about research.
