Relative Strength: 3 Factor vs Composite
Apr 25, 2024
in Relative Strength
The range of Relative Strength tools and backtests on ETFreplay come in two varieties: 3 Factor and Composite.
3 Factor Relative Strength
The Relative Strength (RS) model employed by the Screener, RS Reader and the majority of RS backtests is loosely based on the Sharpe Ratio, which measures return per unit of risk. However, while the Sharpe Ratio effectively equally weights the time period for return and volatility, the RS model takes the Sharpe Ratio concept and decomposes it into three separate factors:
- ReturnA - Higher timeframe total return
- ReturnB - Lower timeframe total return
- Volatility
Volatility is a measure of risk and is the annualized standard deviation of daily returns over the specified lookback period. Risk is uncertainty and the larger the range of possible outcomes, the higher the volatility will be and therefore the greater the risk. Consequently, unlike returns, it is ranked low to high. Therefore, the greater the weight assigned to volatility, the more volatile ETFs are penalized. 1
From these three factors, and the weights assigned to them, the overall rank is calculated. The precise process is fully explained in How The Screener Works.
Both the lookback periods and the weight of each factor can be changed. For example, to rank the ETFs by only 6-month total return, set Return A to '6-Months' and set its weight to 100% (and the weights of ReturnB and Volatility to zero).
As with most models, the shorter the lookback periods chosen, the more responsive to changes the RS model will be. However, this also means that it is more likely to be whipsawed by noise and will have a higher trade frequency. A balance must therefore be struck. If a model proves to be too busy with a particular list, then longer looback periods should be employed to get above the noise (or greater weight assigned to the higher timeframe).
i.e. A model using 6-month ReturnA and 3-month ReturnB will produce less trades than 3-Month and 20-day etc.
The performance of a model can be evaluated using one of the various Relative Strength backtests and the Parameter Performance Summary makes it possible to test numerous different parameter combinations in one go. 2
Relative Strength Composite
The RS Composite model is designed to protect against the possibility of parameter choice misfortune, which can arise when relying on a single lookback period for relative strength.
i.e. though a particular lookback may have historically outperformed other lookback lengths, there's always the possibility that it may underperform in the future.
The RS composite model reduces that risk by diversifying across a range of return lengths. It does this by stepping through the lookback periods, from a specified minimum to maximum, and invests in the top (strongest) x securities from each of those. 3
By using a range of RS lengths, the composite model entirely avoids the risk of being exclusively in, what could transpire to be, the worst performing model variant.
See:
Notes:
- As an extreme example: use the Screener and set the Volatility weight to 100% (ReturnA and ReturnB weights to zero) and the least volatile ETFs will appear at the top of the list.
- Reading the Parameter Performance Summary guidelines is highly recommended
- It is also possible to backtest Mean Reversion, by investing in the bottom (weakest) x securities.
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