Backtesting ETF Trading Strategies

Fidelity did a short study on Tom Lydon’s ETF trading strategy and another trading strategy from portfolio123.com. Lydon is author of The ETF Trend Following Playbook: Profiting from Trends in Bull or Bear Markets with Exchange Traded Funds (I have not read it yet but it is on my list).

The strategy from portfolio123.com is intriguing and similar to a top 20 ETF list I track on the right hand side of the blog. It buys the best 5 ETFs based on 60 day returns and holds for a month and then rebalances.

The study from Fidelity is below. It does not cover an extensive history, but still shows promise for the strategies:

ETF Trading: Tested Strategies

Ideas for how to make the most of your trades

Mike Sincere

August 17, 2009

In today’s competitive trading environment, everyone is looking for a strategy that gives them a competitive advantage. Lots of traders are using the variety and liquidity of exchange traded funds (ETFs) to execute their ideas. Here are some options that have shown strong results in backtesting. There’s no assurance the strategy will perform the same way in the future — conditions may change — but a successful history may make these ideas worth your consideration.

Identify and follow ETF trends
According to Tom Lydon, author of The ETF Trend Following Playbook (FT Press, 2009), and president of Global Trends Investments, ETFs provide traders an opportunity to profit by identifying a specific trend.

“One of the simplest ways to identify trends is by using a simple moving average,” he suggests. “There are huge opportunities to take advantage of trends as they develop. The idea is to buy into the momentum as it goes above its trend line. Hopefully, it will be the beginning of a long-term trend.”

The rules for his ETF trend following strategy are straightforward:

1. Buy the ETF the following day after it crosses above its 200-day exponential moving average (EMA) at the market close.
2. If the ETF goes up 5% above the 200-day EMA, use the moving average as the sell point. Therefore, sell when it crosses below the 200-day EMA.
3. Finally, if the position goes below the 200-day EMA prior to it going 5% above the 200-day EMA, then sell the position when it goes 3% below its 200-day EMA.

For this strategy, Lydon only includes ETFs that have at least $50 million in assets. In addition, although he uses the 200-day EMA, a more active trader can use the 50-day or 100-day EMA.

“A 50-day EMA will identify a shorter-term trend,” he says, “with the idea that you buy above the average and sell below it.” He prefers the 200-day EMA because he’s looking for long-term trends.

The disadvantage of the shorter-term EMA is “you are going to have three to four times the amount of trading than the 200-day,” He says. During volatile times, however, Lydon admits that the 50-day works better than the 200-day.

Backtesting the trend-following strategy

Using Fidelity’s Wealth-Lab Pro,® we entered the data for the trend-following strategy and performed a backtest. Here are the results.

Testing a 50-day moving average over 5 years

50-day moving average over 5 years

Testing a 200-day moving average over 3 years

200-day moving average over 3 years

Monitor your portfolio

When using the trend-following strategy, you have to monitor your ETFs daily. “Once you identify a trend, you don’t know how long you’re going to be in when you buy,” says Lydon. “You have to go in with the idea that half your trades are losing trades. Because you’ve got short-term stop losses on them, the losses will be small. The idea is that if half the trades are profitable, a good chunk of the good trades will more than offset the short-term losses.”

Lydon claims that for most of 2008, almost everything was below its 200-day MA, so he was sitting in cash. “As we got into 2009, a few ETFs popped ahead of the trendline, specifically technology and commodities.”

For the near future, Lydon is watching the S&P 500 carefully, which is close to the 200-day MA. “This could be the beginning of a new bull market. Nevertheless, if you’re looking for an entry point, if the S&P goes above the 200-day MA, that’s a great way to buy in while protecting the downside.”

The Top 5 strategy: rotate into the best-performing ETFs

Since there are so many ETFs, it makes sense to focus on a smaller, more manageable portfolio of ETFs. Marc Gerstein, an independent consultant currently working for portfolio123.com, explains. “First I set the universe and then I create the strategy,” he says. “If you don’t have the universe set properly, there is no strategy that will work.”

Gerstein uses a number of ETF strategies ranging from conservative to aggressive. For his Top 5 strategy, he only looks at ETFs with an average daily volume of at least 5,000 shares. In addition, he eliminates leveraged and short ETFs, HLDRs (Holding Company Depositary Receipts), and municipal bonds. Gerstein cautions that although he doesn’t include commissions in his strategies, they should be considered.

When finished screening, Gerstein ends up with about 500 ETFs, which he sorts. “No one wants to consider 500 ETFs,” he explains, “so I am going to take the five best. The strategy is how I define what I mean by the best.” His simplest strategy looks at the 60-day percentage price changes of the ETFs.

Thereafter, every four weeks, he reruns the screen, re-sorts the remaining ETFs, and buys the top five — selling any already-owned ETFs that no longer qualify under these rules.

“Using this strategy, if you invested $100 on March 31, 2001, by mid-June, 2009, it would have grown to $227.60. Meanwhile, the S&P 500 shrank to $79.50.” He says the average four-week return is 0.98%.

One of the most exciting features of backtesting is the ability to play “what if” games with the data. Gerstein often noticed that on some months, several ETFs with similar objectives clustered at the top of the list. For example, one month all the China ETFs might shine, or perhaps all energy ETFs.

To solve this problem, Gerstein made adjustments to his portfolio. “If there’s a lot of correlation at the top of the list, someone might not want to invest in the top five ETFs,” he says. “So I tested it with the top 15. This gives you flexibility.”
Gerstein says that if you use these strategies, you shouldn’t be concerned with the number of shares you buy. “Worry about the dollar amount and do the division to determine the shares.” He suggests starting with a minimum of $5,000 to $10,000 per ETF.

A word of advice
Although anyone can say an ETF strategy works, backtesting is one of the ways to prove it. Nearly any investment security — stocks, bonds, mutual funds, or options — can be backtested using Wealth-Lab Pro.

On the other hand, because backtesting analyzes past results, there are no guarantees these results can be achieved in the future. Nevertheless, backtesting can give insights into what strategies work — and why.

bullet Fidelity offers online and in-person seminars on trading topics like backtesting and ETFs. Learn more.

(Tell us what you think about this article. E-mail comments to Fidelity.Investments@fidelity.com.)

Michael Sincere is a freelance writer and the author of five books on investing and trading including Understanding Stocks (McGraw-Hill, 2003) and Understanding Options (McGraw-Hill, 2006).

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