Note: The system itself is not original and borrows heavily from the ideas presented by Mebane Faber in his book, “The Ivy Portfolio,” and his paper, “Relative Strength Strategies for Investing.” There is a similar monthly ration system presented on the CXO Advisory website.
Discussion of the Monthly Rotation System
Towards the end of every month, I’ll go through and rank all of the ETFs in the ETF universe (defined below). With that ranking, I’ll take a 1/2 of risk equity position in the Top 2 Performing ETF’s. At the end of the month, I’ll re-rank and shuffle the positions. I’ll also track the performance of the Top 1 and Top 3 ETFs for comparison. As I mentioned here, the risk equity being allocated to the system is $6000 so each position will use an initial cash outlay of $3,000.
Sidenote about Trend Following Systems:
As I mentioned in the article on a Donchian Channel breakout system, I have always traded a Donchian system. For the model portfolio I’m choosing to use this momentum system for two reasons:
1. Trading a monthly rotation system based on momentum is easier to implement.
2. For small accounts, using a monthly rotation system minimizes the impact of commission and avoids going on margin to diversify underlying vehicles.
Measuring Performance for the Monthly Ranking
The system uses an average rate of change (hereafter AROC) over several periods to identify the top performing ETFs. AROC is calculated by averaging the individual rate of change for 1 month, 2 months, 3 months, 6 months, 9 months, and 12 months. The average produces some number, essentially an index, that will be used to rank the ETFs.
The ETF Universe
The ETF universe for the monthly rotation system is made up of unleveraged ETF’s with an average daily volume of at least 50,000 shares. The only asset classes not included in the universe are volatility and inverse ETFs. Some months the rotation system will have highly correlated positions.
Leveraged ETF’s and volatility ETF’s will not be considered for the system because the expected holding period is at least one month. The main reason to exclude the asset classes is that leveraged ETF’s introduce risks beyond price risk and the purpose of the system is only to follow top performing asset classes. For a more thorough discussion on the risks associated with leveraged ETF’s see the following articles:
What differentiates this system
The unique characteristic of this monthly rotation system is that there are no limitations placed on asset classes and it’s just one part of a larger trend following portfolio. Many monthly rotation systems attempt to pick examples to fit within different asset classes and attempt to include stocks, bonds, commodities, foreign stocks, foreign bonds, etc and then rank the choices.