April 21, 2010

Back-Testing ETFs To Improve Your Odds

The naughties (00’s) are often referred to as the lost decade culminating in the financial tsunami of 2008/09.  Total returns (including all dividends) on the S&P 500 were about –9% (-22% in nominal terms) for the entire decade.  With those numbers, it has become difficult to find a rationale for the “Buy and Hold” strategy that has been indoctrinated to the average investor for decades.

But despite the poor performance of stock markets over the past decade, there is ample evidence suggesting that stock picking and other active investing strategies are bound to run into substantial headwind over a longer period of time.  As Tom Lydon of www.etftrends.com suggests in his post: How to Become a Better ETF Trader:

According to a recent TrimTabs study, ETF investors are so bad at picking the right time to buy or short-sell the equity markets that those doing exactly the opposite of what ETF players did in the past 10 years would have ended up making sevenfold profits, reports Oliver Ludwig for Index Universe. 

The likelihood that a similar scenario would apply to most other active trading strategies in general is high and the rationale for that is quite simple: With more frequent transactions, trading approaches the realm of a zero sum game and the probability of outwitting other investors is by definition 50/50 minus transaction costs.  Unless you are an above average investor (trader), you won’t beat the crowd.  Although this may seem an oversimplification in terms of stock trading, an active investment strategy should on average under-perform the market by the amount of transaction costs incurred. 

So we have established that “Buy and Hold” didn’t work in the past decade and that market timing is also a particularly challenging task.   How can one improve the odds and what is the right strategy?

Tom Lydon suggests a few simple rules:

  • Implement a simple strategy. Studies have shown time and again that there’s a direct correlation between how complicated a strategy is and how often you’ll use it. Keep it simple, silly.
  • Have a stop loss. “It’s easy to buy and hard to sell,” goes the adage. Make selling easier by knowing when you’ll do it. And then do it.
  • A simple strategy we suggest is trend following by using the 200-day moving average to determine when you buy and sell. You’re buying when a trend is there, and only when the trend is there. This allows you to check your emotions at the door.

Of these 3 basic trading tips, the third one is the most concrete example of a relatively simple and verifiable trading strategy. Brokerage firms often provide free access to research and trading analytics.  But these days, there are also free online resources available that let you back-test whether the proposed strategy would have worked for any given ETF. Let’s take this 3rd rule for a test drive then...

As a example, please consider www.etfreplay.com (no affiliation with the author) which has a tool allowing you to back-test a strategy using moving averages:  http://www.etfreplay.com/backtest_ma.aspx

Enter the ticker symbol SPY (the ETF for the US benchmark S&P500), use the suggested 200-day moving average and select “Trade On: Day of Cross”.  Choose your time frame, in this case, the past decade and hit the button to run the Back-test.  Here are the graphical results:


The proposed strategy seemed to have worked quite well with a more than 3:1 ratio favoring the 200 day moving average over the buy and hold period (Note: Returns are calculated from date of first backtest buy). 


Winning vs Losing Trades

Avg Win vs Avg Loss

Return %


There are  a few caveats however, again pointing towards a difficulty with regard to timing and money management.  For starters, the first trade did not occur until January 2002 which means staying on the sidelines for 2 years, had we implemented the strategy in January 2000.   That would have required a lot of patience!  Perhaps more difficult even for seasoned traders is the necessity to stick to a strategy during times when patience and conviction are severely tested.  The first 6 trades of this strategy were all losing money, albeit small percentage losses.  But the fact that the majority of the trades (77%) were losing trades can shatter the guts of the most confident traders.  Sticking to a strategy when the first few trades aren’t working isn’t everyone’s cup of tea.


Avg Days in Trade

Max Consecutive Trades

Max Equity Drawdown %


In closing, I’d like to note that as with any trading strategy, simulated results from a backview mirror perspective are always to be taken with a grain of salt.  While the proposed strategy appears to have worked for the benchmark S&P 500 it may or may not work for other indices or other ETFs.  Please also note that this is just one example of an easy to implement trading strategy - there are many others.  In terms of an overall financial plan, a tailored asset allocation may be much more important and prove more successful over time than a serious of specific investments or individual trades, no matter what timing or trading strategy may be adopted.  Usual disclaimers and general investment risk disclosures apply here as well. 

Having said that, there are more and more trading tools available now that allow individual investors to test and verify if a given investment strategy could work, something which was available to only professional traders until recently.  Overall, the easier and often free access to professional trading tools and investment analytics should make for better informed and more educated investors.  But don’t take my word for it, test it yourself. 

Neither the information nor any opinion contained in this communication constitutes a solicitation or offer by us to buy or to sell any securities, futures, options or other financial instruments or to provide any investment advice or service. Each decision by you to do any investment transactions and each decision whether a particular investment is appropriate or proper for you is an independent decision to be taken by you. In no event should the content of this communication be construed as an express or an implied promise, guarantee or implication by or from us that you will profit or that losses can or will be limited in any manner whatsoever. Past results are no indication of future performance. Please note that there is no requirement and no commitment to make any payments to FX Investment Strategies LLC in order to access our published information be it via email or via website publication. All information is publicly available without any required monetary consideration.  Any payments or donations made by you are deemed to be voluntary and cannot be considered as payments for investment advice given to you.

No comments: