Sector ETF Momentum with Selective Shorting of Losers
Posted in Momentum Investing, Technical Trading
July 9, 2010
A reader proposed a variation of the 6-1-SMA10 strategy from “Simple Sector ETF Momentum Strategy Performance”, which allocates all funds at the end of each month either to the one sector exchange-traded fund (ETF) from the following list with the highest total return over the past six months or to cash, depending on whether the S&P 500 Index is above or below its 10-month simple moving average (SMA):
Materials Select Sector SPDR (XLB)
Energy Select Sector SPDR (XLE)
Financial Select Sector SPDR (XLF)
Industrial Select Sector SPDR (XLI)
Technology Select Sector SPDR (XLK)
Consumer Staples Select Sector SPDR (XLP)
Utilities Select Sector SPDR (XLU)
Health Care Select Sector SPDR (XLV)
Consumer Discretionary Select SPDR (XLY)
The proposed variation (6-1-SMA10:Short Loser) replaces 6-1-SMA10 cash positions with short positions in the sector ETF with the lowest total return over the past six months. Using monthly dividend-adjusted closing levels for the sector ETFs, the S&P 500 index and the 3-month Treasury bill (T-bill) yield over the period 12/98-6/10 (139 months), we find that:
The following chart shows the distribution of the 6-1-SMA10:Short Loser strategy’s 78 long and 54 short positions over the entire sample period. The energy sector dominates the long positions, while the technology and financial sectors dominate the short positions.
How does applying the 6-1-SMA10:Short Loser strategy translate into cumulative returns?
The next chart compares the cumulative values of $10,000 initial positions in the 6-1-SMA10 and 6-1-SMA10:Short Loser strategies over the sample period. Calculations derive from the following assumptions:
- Reallocate at the close on the last trading day of each month (assume that total six-month past returns for the ETFs can be calculated just before the close).
- Trading (switching) friction is 0.25% of the balance whenever there is a change in holdings.
- Return on cash for the 6-1-SMA10 strategy is equal to the T-bill yield at the time of allocation.
- Ignore shorting costs and tax implications of trading.
The 6-1-SMA10 (6-1-SMA10:Short Loser) strategy switches 37 (52) times over the sample period. At the assumed level of switching friction, the two strategy variations perform very similarly during bull markets and very differently during bear markets, but it is unclear whether shorting momentum losers while the S&P 500 Index is below its 10-month SMA (“cash” conditions) yields a long-term advantage.
Including costs for shorting would lower the performance of the 6-1-SMA10:Short Loser strategy during “cash” conditions.
How do the monthly return statistics for the two strategies compare during “cash” conditions?
The following table summarizes the average monthly net returns and the standard deviations of monthly returns for the 6-1-SMA10 and 6-1-SMA10:Short Loser strategies during the 54 months the former is in cash, based on the assumptions above. The 6-1-SMA10:Short Loser strategy has a much higher average return but also a much higher volatility during these months. As shown above, the volatility works against the higher average in generating cumulative return. Including costs for shorting would lower the average monthly return of the 6-1-SMA10:Short Loser strategy.
Note that:
- The difference in performances for these two strategies is sensitive to the number and duration of bear markets during the sample period. The available sample for the sector ETFs is very short in this regard (two bear markets).
- Iterating multiple tests on a given sample introduces data snooping bias (finds lucky rules/parameter settings). There may also be incremental “second hand” data snooping bias when revisiting a rule/parameter setting isolated by someone else who used a similar sample. Data snooping bias is especially pernicious for small samples.
In summary, given the short sample period and modest cumulative return increment, evidence from simple tests does not support a belief that, over the long run, shorting sector ETF momentum losers beats cash while the S&P 500 Index is below its 10-month simple moving average.
