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Schwab Commission Free ETF Rotation System Backtest $SPY, $TLO, $PCY, $RWO, $SHY

I’ve been doing a lot of writing about Momentum Based ETF Rotation Systems lately and for good reason.  The systems are low maintenance and have historically provided a good return in a variety of market conditions.  In this post we’re going to look at backtest results for the Schwab Commission Free ETF Rotation System.  We’ll explore the Basic Rotation System backtest in a future post.

Why Charles Schwab?

cityAn increasing number of brokers have started offering commission free ETF trading, however, the terms of “free” vary by broker.  In some cases, the brokers have a minimum holding period of up to 30 days and require you to enroll in a commission free program.  My idea of free is where you don’t do anything and it’s free.  Fortunately, Schwab has the same idea and they offer access to around 175 commission free ETF’s.  In addition to offering a large number of commission free ETF’s, Schwab doesn’t require you to enroll in the program and there is no minimum holding period.  Other brokers aren’t quite as generous.  On top of that, I already have some retirement accounts with Schwab so I didn’t need to open a new account.  Easy is good.

Note that I don’t have any vested interest in promoting Schwab and I don’t receive any benefits.  I just think their Commission Free ETF program is that good and they’ve always been great to work with from a customer service standpoint.

System Rules:

The rules for the ETF Rotation Systems are simple and can also be found in this post.

  1. Identify a basket of markets to trade (see the list below).  In this case, we want a broad range of markets that gives us access to theoretically uncorrelated asset classes.
  2. On a monthly basis, rank the markets based on the 3 month total returns.  This is generally done a couple of days prior to the end of the month.
  3. Allocate 50% of desired equity to each of the top two markets as long as the ETF’s are trading above their 6 month moving average.  For example, if the second ranked market is below the 6 month moving average we don’t buy that market.
  4. If one of the top two positions is trading below the 6 month moving average, hold that portion of equity in cash or a Short Term Treasury ETF.  In the backtest below, I used the iShares 1-3 Year Treasury Bond ($SHY).
  5. Ignore price fluctuations during the month and re-rank at the end of the month.

Charles Schwab Commission Free ETF Rotation System Markets:

Note that the markets presented in this table have been updated since the backtest and include a couple of additional ETF’s that were not present in the backtest below.  The list of ETF’s in the backtest follows.

Schwab Commission Free ETF Rotation SystemDescriptionExposure
SCHBSchwab US Broad Market ETFUS Equities
SCHASchwab US Small CapUS Equities
PGXPowershares Preferred PortfolioUS Preferred Stock
SCHFSchwab International Equity ETFInternational Equities
SCHESchwab Emerging Markets EquityInternational Equities
SCHCSchwab International Small Cap EquityInternational Equities
SCHHSchwab US REIT ETFReal Estate (US)
RWOSPDR Global Real Estate ETFReal Estate (International)
SCHZSchwab Aggregate Bond ETFUS Bonds
SCHRSchwab Intermediate Term Treasury ETFUS Government Bonds
TLOSPDR Barclays Long Term Treasury ETFUS Government Bonds
HYMBSPDR S&P High Yield Municipal Bond US Municipal Bonds
SCHPSchwab US TIPS ETFUS Government Bonds
PCYPowershares Emerging Markets Sovereign Debt PortfolioInternational Bonds
BWXSPDR Barclays International Treasury Bond ETFInternational Bonds
USCIUnited States Commodity Index Commodity
SGOLETFS Physical Swiss Gold SharesCommodity

Backtest Results:

The equity curve for the rotation system backtest is shown below.  It’s worth noting that some of the ETF’s lack a significant amount of historical data and the test was run for the longest period possible based on that data.

Schwab ETF Rotation System Backtest

We all like an upward sloping equity curve when we backtest something and the system performed well over the test period.  Most people will gravitate to the CAGR, which was around 14.6% and the Sharpe Ratio of 0.97.  However, I’m significantly more impressed with the -13.2% maximum draw down that took place during 2008.  Moving out of underperforming assets and into outperforming assets is the purpose of trading an ETF Rotation System and, in this test, the system did just that.

The system was up money in about 65% of the periods, which potentially makes it easier to trade than most Trend Following systems that tend to have a higher percentage of losing trades.  It’s interesting to note that the system has been underperforming since 2011 while the S&P 500 ($SPY) has been racing higher.  That being said, the S&P 500 is something of an arbitrary benchmark and is used more as a measure of buy and hold for our purposes.

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ETF Holding Periods:

In the table below, we’re looking at the number of days each ETF was held.  Over the test period the system held the Long Term U.S. Treasury ($TLO), Emerging Markets Bonds ($PCY), and Global Real Estate the longest ($RWO).

Schwab ETF Rotation System

Where does that leave us?

What I take away from the ETF Rotation System test is that momentum investing appears to be a relatively low maintenance way to achieve good risk adjusted returns.  My biggest criticism of the test is that we’re covering a short period of time and the returns could potentially be skewed by favorable market conditions.  That being said, I’m willing to devote a portion of my personal accounts to trading the systems as a way to forward test them for everyone to see.  In other words, I believe in the merits of the systems.

More Information:

If you want more information on ETF Rotation Systems, make sure to check out the Market Momentum Newsletter and the Schwab Commission Free ETF Rotation System Results.

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  • The Lazy Trader

    Thanks for sharing Dan!
    Question, did you try applying a volatility component to the formula for selecting the best ETFs? Looks like you are only basing your selection on the best 3 month return but I’m curious on whether you backtested adding a volatility penalization and didn’t obtain better results.
    Keep up the good work,
    LT

    • Thanks LT. I toyed around with the volatility component a little bit, but in the end I didn’t use it because it didn’t seem to create a significant improvement in returns. It’s possible that I didn’t explore it deeply enough, but I also prefer systems that are less optimized.

      Most people would probably agree that big trends tend to start in low volatility environments and that volatility increases as the trend progresses. Intuitively, I don’t like to penalize or reward a market because volatility is low or high. It’s something I might look into going forward, but I’m not using it for now. Thanks for the comment and I’m enjoying reading about the rotation systems on your blog as well.

      Dan

  • kapil1022

    Hi Dan, A key rule for risk management is your 6 month moving average rule (rule 3). An interesting comparison would be to compare the rotation system to just trading the spy with rule 3 applied. Does the value come from rotating etfs or from the stop loss.

    • That’s a good point Kapil and it’s a scenario that I didn’t test. I could pull some $SPY data into excel pretty easily and run a comparison. I’ll keep you posted. Thanks!

  • g g

    hi. thanks for sharing. are you still investing with strategy? haven’t seen an update for a while.
    One little problem though.. I tried the same backtest at ETFreplay and it appears the good performance during the 2008 meltdown was due to there being insufficient data to qualify for consideration all but 3-5 ETFs (mostly bonds) in the portfolio in 2008. Most equity ETFsin the portfolio are founded in 2009 or later.
    the strategy outperforms SPY in 2011 but underperforms in 2015 in the most recent corrections.

    • Hi gg and thanks for the comment. You’re right, I moved away from this strategy earlier this year (around the time this post was written). Most of my focus has been redirected towards options trading and primarily Butterflies.

      You’re right that the ETF’s in this particular system weren’t as available during 2008, but it’s unlikely that any of the equity ETF’s would have been chosen if they existed. The main reason I say that is the moving average filter would have removed them from consideration.

      Yeah, the rotation systems seem to outperform and underperform during different market environments. Based on some other writing I’ve seen online, I’ve gotten the sense that 2015 has been a bad year for the systems.

      Dan