Mastering Sector Momentum: Faber's Research on Rotational Trading Strategies | Papers With Backtest: An Algorithmic Trading Journey

Description

Are you ready to elevate your investment game and uncover the secrets behind sector momentum? In this thrilling episode of Papers With Backtest: An Algorithmic Trading Journey, we delve deep into Maybane Faber's groundbreaking research on Relative Strength Strategies for Investing, revealing how a shift in focus from individual stocks to entire sectors can dramatically enhance your trading performance. By harnessing the cyclical nature of the market, investors can leverage sector momentum to achieve significant returns that often outpace traditional buy-and-hold strategies.

The hosts meticulously unpack Faber's robust methodology, which draws on an extensive analysis of data from 10 industry portfolios dating back to 1926. Discover the simple yet powerful trading rules that have led to consistent market outperformance, including the innovative approach of ranking sectors based on trailing returns and implementing a monthly rebalancing strategy. This episode is not just theoretical; it's a practical guide to understanding how sector rotation can be a game-changer in your investment portfolio.

Throughout the discussion, we highlight the impressive results of Faber's strategies, showcasing their ability to deliver substantial returns while frequently outperforming conventional investment approaches. However, we also address the potential drawbacks, including the inevitable market volatility that can impact sector performance. Risk management is key, and we explore essential techniques such as utilizing a 10-month moving average for hedging and diversifying across various asset classes to mitigate risks.

As we navigate the intricacies of sector momentum and rotational trading, we emphasize the importance of tailoring strategies to fit individual investor needs. Understanding the risks involved is crucial for anyone looking to implement these advanced trading strategies successfully. Our conversation not only sheds light on the theoretical aspects but also prepares you for practical implementation, ensuring you are equipped with the knowledge to adapt these strategies to your unique investment style.

Don't miss the opportunity to gain insights that could transform your approach to investing. Stay tuned for future episodes, where we will dive even deeper into advanced strategies and practical applications, guiding you on your journey through the fascinating world of algorithmic trading. Join us as we explore the potential of sector momentum and unlock new avenues for investment success in Papers With Backtest: An Algorithmic Trading Journey.

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Transcription

Speaker #0
Hello, welcome back to Papers with Backtest podcast. Today we dive into another algo trading research paper.
Speaker #1
We're going to be looking at a strategy from Maybane Faber's Relative Strength Strategies for Investing. You know, picking winning stocks is hard enough. Oh yeah. But this paper goes a step further. It explores applying momentum, not just to individual stocks, but to entire sectors of the U.S. stock market.
Speaker #0
Ah, sector momentum. I've heard that can be a powerful way to play the market rotation. Instead of trying to pick individual winners, you're betting on entire industries. So did Faber find that this approach actually works?
Speaker #1
He did. The results are pretty compelling. But before we get into those, let's make sure we're on the same page about what momentum and rotational trading actually mean.
Speaker #0
OK, let's break it down. When we talk about momentum, we're basically saying, hey, this asset, whether it's a stock or a whole sector, has been doing well recently. Let's ride that wave and hope it continues.
Speaker #1
Exactly. It's the whole idea of the trend is your friend. And rotational trading takes that concept and applies it to different sectors of the economy.
Speaker #0
Because not all sectors perform well at the same time, right? Yeah. Like during a tech boom, technology stocks might surge while energy lags behind. Then when oil prices spike, the energy sector could take the lead.
Speaker #1
Precisely. It's like a game of musical chairs with investors rotating into the sectors that are currently in favor. And Faber's research shows that this rotation can be quite powerful. profitable.
Speaker #0
So how did he actually test this out? What was his methodology?
Speaker #1
Well, he went way back in time. He used data on 10 different industry portfolios going all the way back to 1926. Wow,
Speaker #0
1926. That's almost a century of data. Must have taken ages to crunch all those numbers back then.
Speaker #1
It certainly wasn't as easy as it is today with our fancy computers and software, but that long history gives us a very robust data set, which is important when you're trying to draw statistically significant conclusions.
Speaker #0
Makes sense. So with those 10 sectors, how did he actually implement this momentum and rotation strategy? What were the specific trading rules?
Speaker #1
The strategy itself is remarkably simple. Each month, he ranked the sectors based on their trailing returns. Trailing returns, just so we're clear, are the returns an asset or strategy has generated over a specific period in the past.
Speaker #0
Got it. So if health care had the highest returns over the past three months, it would be at the top of the list, right? Then what? Do you buy all 10 sectors or just the top performers?
Speaker #1
That's where it gets interesting. He tested different portfolio sizes, buying the top one, two, or three sectors based on their trailing returns. And then, of course, you'd rebalance every month, selling the ones that fell out of favor and buying the new leaders.
Speaker #0
So you're constantly adjusting the portfolio, always chasing the hottest sectors. But did this actually lead to better returns than just buying and holding a diversified portfolio?
Speaker #1
Here's where it gets exciting. The relative strength strategy consistently outperformed the market over the entire period studied. And it wasn't just a fluke in one particular timeframe. It worked across various lookback periods for momentum, whether he used a one month, three month, or even a 12 month look back.
Speaker #0
Consistently outperforming the market over almost a century. I'm all ears. Give me the numbers. What kind of returns are we talking about?
Speaker #1
Well, the paper mentions eye performance of roughly three, 6% per year. Of course, that's before fees and taxes, which are real world factors any investor needs to consider.
Speaker #0
Three to six percent extra per year can really add up over time. That's the kind of edge that can make a big difference in the long run. Did you mention anything about how often this strategy actually beat the market?
Speaker #1
Yes. And this is the part that really stood out to me. It beat the buy and hold approach about 70 percent of the years tested. Think about that for a second. If you had a strategy that won seven out of 10 times. Yeah. Wouldn't you be pretty happy with those odds?
Speaker #0
I'd take those odds any day. It's not about being right all the time. It's about having an edge that tilts the scales in your favor over the long haul. Okay, so far, this sector momentum strategy is sounding pretty impressive. But I'm guessing it's not all sunshine and rainbows. What are some of the potential drawbacks we need to consider?
Speaker #1
You're right. No strategy is perfect. The main drawback here is that this system assumes you're fully invested in stocks at all times. which means it's still going to experience the ups and downs of the market as a whole.
Speaker #0
So when the market takes a dive, this portfolio is coming down with it. That sounds a bit unnerving. Did Faber offer any solutions to mitigate that risk?
Speaker #1
He did. He explored a couple of approaches to make the strategy more robust.
Speaker #0
Okay, I'm all ears. Let's talk risk management.
Speaker #1
The first solution involved a simple but effective hedging technique using a 10-month simple moving average, or SMA. You know that line on the chart that smooths out price fluctuations?
Speaker #0
I've seen those moving averages, but I've never really thought of them as a hedging tool. How does that work?
Speaker #1
Basically, when the S&P 500 drops below its 10-month SMA, it's a signal that the broad market is trending down. The strategy then goes to cash, essentially selling all the sector ETFs and moving to the sidelines until the market shows signs of recovery.
Speaker #0
So it's like a circuit breaker for the whole portfolio. When the market gets shaky, you hit the off switch and wait for the storm to pass. Did that actually improve the results?
Speaker #1
Significantly. This simple hedging technique substantially reduced volatility and drawdowns. The portfolio still made money, but it rode out the market storms much more smoothly.
Speaker #0
That's a pretty elegant solution. So what was the second approach?
Speaker #1
The second solution involved diversifying beyond just U.S. stocks.
Speaker #0
You know, you've mentioned a couple of times that different sectors perform differently at different points in the economic cycle. Right. But wouldn't the same logic apply to different types of assets altogether, like stocks versus bonds or even real estate and commodities?
Speaker #1
That's exactly the idea. Just like sectors rotate, different asset classes have their time in the sun. Faber actually explores this in more depth in his book, The Ivy Portfolio, where he adds global stocks, bonds, real estate through REITs and commodities to the mix.
Speaker #0
So by spreading your bets across different asset classes, you're not only chasing returns, but also trying to smooth out the ride.
Speaker #1
Precisely. And the beauty is you can still apply the same momentum and rotation principles to this broader portfolio. You'd be looking for which asset classes are showing the strongest recent performance and rotating into those.
Speaker #0
OK, so we have two potential solutions here hedging with a moving average to protect against downturns and diversifying across different asset classes to spread the risk. Did the paper look at combining these two approaches?
Speaker #1
Now, that's where things get really interesting and a bit more advanced. It's a topic worthy of its own deep dive in the future. But I can tell you that combining both hedging and diversifying led to even better risk adjusted returns.
Speaker #0
Ooh, a teaser for a future episode. I like it. OK, so we've got these strategies in there. impressive back-tested results. But let's be real for a second. This research was all done using historical data. How much confidence can we really have that these strategies will work in the future?
Speaker #1
That's the eternal question in investing, isn't it? Past performance is never a guarantee of future results. But the fact that this strategy has worked over such a long period, encompassing various market cycles and economic upheavals, does lend it a degree of credibility. It suggests there might be something fundamentally sound about following momentum and rotating between sectors or asset classes.
Speaker #0
I see what you mean. A track record spanning almost a century is hard to ignore. It's not like we're talking about a few lucky years in a bull market. What else should we consider when thinking about how to actually put these strategies into practice?
Speaker #1
One key difference between back then and now is the ease of implementation. Back in the 1920s, trying to trade all these sectors would have been incredibly costly and complex. Today, thanks to ETFs, It's much simpler and cheaper to get exposure to specific sectors or asset classes.
Speaker #0
ETFs have been a game changer for this type of strategy. Low costs, easy to trade. It's like building blocks for your portfolio.
Speaker #1
Exactly. And another practical consideration is taxes. These strategies involve a fair amount of buying and selling, which can trigger tactical events. So it's generally a good idea to use them in tax-advantaged accounts like IRAs or 401ks. That way, you can keep more of your... your profits.
Speaker #0
Solid advice. Tax efficiency is crucial, especially for strategies with regular rebalancing. Well, this has been a fascinating deep dive into sector momentum. We've covered the basic idea, the research, the results, and even some practical considerations for putting it into action.
Speaker #1
It's really a testament to the power of relatively simple quantitative strategies. By systematically following momentum and rotating between sectors or asset classes, investors can potentially outperform the market in the long run.
Speaker #0
Who doesn't love the sound of that? But as always, we encourage our listeners to do their own research, understand the risks involved, and tailor any strategy to their own individual needs and goals.
Speaker #1
Absolutely. Every investor is different. What works for one person might not work for another. Critical thinking and informed decision making are essential in the world of investing. Don't just blindly follow any strategy. Make sure you understand why it works and if it's right for you.
Speaker #0
Well said. Any final thoughts for our listeners before we wrap up part one of this deep...
Speaker #1
You know, what's really striking about this research is how it highlights the cyclical nature of markets. Sectors and asset classes inevitably go through periods of outperformance and underperformance. The key is to have a systematic way to identify those shifts and position yourself accordingly.
Speaker #0
So the takeaway here is to think beyond individual stocks. Zoom out and consider the broader trends affecting different parts of the economy and different asset classes. Use momentum and rotation to ride those waves. That's some insightful stuff to chew on. We'll pick up this conversation in part two, where we'll delve deeper into the practical aspects of implementing these strategies.
Speaker #1
We'll be exploring specific ETFs, trading platforms, and even backtesting tools to help you put these ideas into practice.
Speaker #0
Sounds like a plan. We'll see you in part two.
Speaker #1
Welcome back to part two of our deep dive into sector momentum.
Speaker #0
We left off talking about how much easier it is to implement these strategies today, thanks to ETFs.
Speaker #1
Right. ETFs have really democratized access to different sectors and asset classes. If you're trying to do this decades ago, you would have needed to buy and sell tons of individual stocks every month.
Speaker #0
Oh,
Speaker #1
wow. Can you imagine the trading commissions?
Speaker #0
Yikes. That sounds like a logistical nightmare, not to mention expensive. But with ETFs, you can buy a whole basket of stocks in a specific sector with just one trade. So let's get specific. If someone wanted to build a sector rotation strategy based on Faber's research, what are some ETFs they could consider?
Speaker #1
Well, you have a lot of choices these days, but luckily for us, the paper looks at 10 broad sectors of the US economy. You can easily find an ETF for each.
Speaker #0
10 sectors, that's a good starting point. I'm ready to build my momentum machine. Hit me with those tickers.
Speaker #1
All right, let's start with technology. A very popular ETF for that sector is the Technology Select Sector SPDR Fund, ticker symbol XLK. It holds a bunch of familiar names like Apple, Microsoft, NVIDIA, and so on.
Speaker #0
XLK, that's one I've heard of. What about healthcare? Always a big sector, especially as the population ages.
Speaker #1
For healthcare, a good option is the Healthcare Select Sector SPDR Fund, ticker symbol XLV. This one covers everything. From pharmaceuticals to medical equipment and health insurance companies.
Speaker #0
So XLK for tech, XLV for health care. Yeah. Any others you'd recommend?
Speaker #1
Let's see. We should probably include consumer staples since people always need things like food and household products regardless of the economy. The consumer staples select sector SPDR fund, ticker symbol XLP, would be a good choice for that. It holds companies like Procter & Gamble, Coca-Cola, Walmart, and those types of businesses.
Speaker #0
XLP. Got it. Yeah. So we've got tech. healthcare and consumer staples. What if you're feeling bullish on energy or maybe the financial sector?
Speaker #1
If you're looking at energy, there's the Energy Select Sector SPDR Fund, ticker symbol XLE. It tracks the performance of oil and gas companies as well as energy equipment and services providers.
Speaker #0
Interesting. So even if you don't want to pick individual oil stocks, you can still get exposure to that sector through XLE. And what about financials?
Speaker #1
For financials, you have the Financial Select Sector SPDR Fund, ticker symbol XLF. It includes a wide range of banks, insurance companies, and other financial institutions.
Speaker #0
XLF, got it. Okay, that's five sectors covered. I'm assuming there are ETFs for the remaining five as well.
Speaker #1
Absolutely. You can find ETFs for industrials, materials, utilities, real estate, and consumer discretionary, covering pretty much every corner of the market. We could spend the whole episode just listing ETFs, but I think you get the idea.
Speaker #0
Yeah, I think our listeners are probably getting ticker overload by now. But the point is, there's an ETF for just about anything these days. So let's say we've picked our 10-sector ETS. Now we need to figure out when to buy and sell them based on momentum. Do we need some fancy software to do all those calculations?
Speaker #1
You could certainly build your own custom trading algorithms if you have the programming skills. Right. But for most people, there are easier ways. Several online platforms offer tools specifically designed for backtesting and implementing momentum strategies.
Speaker #0
Backtesting. That sounds intriguing. You've mentioned it a couple of times now. Can you explain what that is and why it's so important?
Speaker #1
Think of backtesting like a flight simulator for your trading strategy. Okay. It allows you to test your ideas using historical data so you can see how they would have performed without actually risking any real money.
Speaker #0
Ah, so it's like a practice run before you go live with your strategy.
Speaker #1
Exactly. You can plug in your trading rules like the momentum lookback periods and portfolio size. The software will simulate how the strategy would have performed over different market conditions.
Speaker #0
Okay, so you can see if your brilliant idea actually works or if it would have blown up your account five years ago. Sounds pretty useful. Are there any particular backtesting platforms you'd recommend?
Speaker #1
There are a few popular ones out there. TradingView is great for its charting capabilities and has a pretty robust backtesting feature. Portfolio Visualizer is another good option, and it's free to use, which is always a plus. Yeah. Some brokerage accounts even have backtesting tools built into their platforms.
Speaker #0
So there are options for every budget and level of expertise. Great. So we've chosen our ETFs. We've backtested our momentum strategy. We're feeling confident. We're ready to trade, right? Just need to open a brokerage account and start placing orders.
Speaker #1
Well, hold your horses. There are a few more things to consider before you jump in headfirst. You don't want to go all in on a strategy without understanding the risks and practicalities.
Speaker #0
Alright, let's talk risk management. What else do we need to be thinking about?
Speaker #1
First of all, not all brokerage accounts are created equal, especially when it comes to trading ETFs. You'll want to find one that has low commissions because we'll be doing a fair bit of buying and selling with this strategy. You also want a good selection of ETFs to choose from and a platform that's easy to use for placing trades and monitoring your portfolio.
Speaker #0
Low costs and ease of use are definitely important. Anything else?
Speaker #1
The most important thing is to know your own risk tolerance. Right. Remember, even though these strategies can potentially beat the market, there are no guarantees. You need to be comfortable with the fact that the market can be volatile and your portfolio will experience ups and downs along the way.
Speaker #0
So don't bet the farm just because you had some good backtest results.
Speaker #1
Exactly. Start small, test the waters with an amount you're comfortable losing. and gradually increase your position size as you gain more confidence and experience.
Speaker #0
That's sound advice. And what about those hedging techniques we discussed earlier? How would someone actually put those into practice?
Speaker #1
Let's revisit that 10-month SMA approach. It's actually pretty straightforward to implement. Most charting platforms will let you add a moving average to your charts. You can also easily track it in a spreadsheet if you're so inclined.
Speaker #0
Okay, so I've got my chart, I've got my moving average line, now what?
Speaker #1
When the S&P 500 closes below its 10-month SMA, that's your signal to sell your sector ETFs and move to cash. You can hold your cash in a money market fund or a short-term treasury ETF, something that's considered very low risk.
Speaker #0
It's like a safety net for your portfolio. When the market starts to look shaky, you step back and wait for things to improve.
Speaker #1
Exactly. You're not trying to time the market perfectly. You're just trying to avoid the worst of the downturns. Of course, there are other hedging strategies you could consider, like using options or inverse ETFs, but those can be more complex and have their own risks.
Speaker #0
Let's not overwhelm our listeners with too much complexity all at once. Right. Better to start simple and master the basics. Speaking of basics, you know one thing that's often overlooked? The psychological side of trading.
Speaker #1
You mean how our emotions can get in the way of making rational decisions?
Speaker #0
Exactly. Fear and greed are powerful forces. and it's easy to get swept up in the hype or panic of the market. How do we avoid letting our emotions sabotage our strategy?
Speaker #1
That's where having a well-defined plan comes in. Write down your trading rules, stick to them, and don't second guess yourself. You're not going to be right all the time, and that's okay. The key is to have a process you trust and follow it consistently.
Speaker #0
So discipline and emotional control are just as important as the technical aspects of the strategy.
Speaker #1
Absolutely. And remember, this is a long-term game. You're not going to get rich quick. Focus on building a robust, well-tested strategy and let the power of compounding work its magic over time.
Speaker #0
Right. Patience and consistency are key in investing. OK, we've covered a lot of ground in this part, too. We've talked about ETFs, backtesting platforms, brokerage accounts, risk management and even the psychology of trading. Anything else we should address before we wrap up this part?
Speaker #1
You know, one thing we should emphasize is that this research is just a starting point. It gives us a framework to think about, but it's not a plug and play system. Every investor needs to adapt these concepts to their own situation and risk tolerance.
Speaker #0
Right. There's no one size fits all solution in investing. You need to do your own research, understand the risks involved, and tailor the strategy to your own individual needs and goals.
Speaker #1
Exactly. And that's where the real fun begins. You can take these concepts and run with them. You can experiment with different ETFs, different look. look back periods, different hedging techniques. You can even combine sector momentum with other strategies. The possibilities are endless.
Speaker #0
So it's about taking what we've learned, putting it into practice, and constantly learning and improving along the way.
Speaker #1
Absolutely. That's the beauty of algorithmic trading. It's a continuous process of learning, adapting, and optimizing. And who knows, you might even discover some new insights that Faber himself didn't consider.
Speaker #0
Well, that's an inspiring thought. So for our listeners who are ready to take the next step, what's in store for part three of our deep dive?
Speaker #1
In the final part, we'll be diving into even more advanced concepts. We'll explore how to combine sector momentum with a global asset class rotation, taking the IV portfolio concept to the next level. We'll also touch on some more sophisticated backtesting techniques and resources.
Speaker #0
Sounds like we'll be taking this momentum strategy to a whole new level. Can't wait. We'll see you in part three. Welcome back to part three of our deep dive into sector momentum.
Speaker #1
In this final part, we're going to expand our horizons beyond just U.S. stocks.
Speaker #0
Okay.
Speaker #1
Remember how we talked about Faber's Ivy portfolio concept? Yeah. We're going to see how we can apply the same momentum and rotation principles to a globally diversified portfolio.
Speaker #0
Okay, so instead of just rotating between 10 sectors of the U.S. stock market, we're now talking about a much broader range of assets. We've got U.S. stocks. international stocks, bonds, real estate, commodities. It's like we're playing a bigger game of musical chairs now.
Speaker #1
Exactly. We're casting a wider net looking for opportunities wherever they might arise. And the good news is the ETF universe has exploded in recent years. Oh, wow. You can now find an ETF for pretty much every imaginable asset class.
Speaker #0
So if I'm feeling bullish on Brazilian bonds or Vietnamese real estate, there's probably an ETF for that.
Speaker #1
Probably. But let's focus on some of the core asset classes that Faber includes in his Ivy portfolio. For broad exposure to global stocks, you have ETFs like the Vanguard Total World Stock ETF, ticker symbol VT. VT.
Speaker #0
Got it. That sounds like a simple way to get exposure to thousands of stocks across the globe. What about bonds? Any ETFs you'd recommend for that asset class?
Speaker #1
For a broad-based bond portfolio, a good starting point would be the Vanguard Total Bond Market ETF, ticker symbol BND. This one holds a mix of U.S. government bonds, corporate bonds, and mortgage-backed securities.
Speaker #0
BND. OK. So we've got VT for global stocks, BND for bonds. We're starting to build our global momentum machine. What's next?
Speaker #1
Well, we can't forget about real estate. A popular ETF for that is the Real Estate Select Sector SPDR Fund, ticker symbol XLRE. This one mainly holds real estate investment trusts or REITs, which own and manage various types of properties.
Speaker #0
That's LRE for real estate. Makes sense. And I'm guessing we'll need an ETF for commodities too.
Speaker #1
Of course. You have a few options there. One is the Invesco DB Commodity Index Tracking Fund, ticker symbol DBC. This ETF tracks a broad basket of commodities, including energy, metals, and agricultural products.
Speaker #0
Wow, so many ETFs to choose from. It's amazing how easy it is to build a truly diversified portfolio these days. But I have a feeling the momentum calculations and rotation decisions might get a bit more complicated when you're dealing with so many different asset classes.
Speaker #1
That's where our trusty backtesting tools come in. Remember those? Yeah. They can help us analyze the historical performance of these various asset classes and see which ones have tended to exhibit the strongest momentum.
Speaker #0
Right. We can use backtesting to figure out not only which asset classes to include, but also how to allocate our portfolio and how often to rebalance.
Speaker #1
Exactly. You can experiment with different momentum lookback periods, different portfolio weights and different rebalancing frequencies. The software will simulate how those decisions would have impacted your returns over time.
Speaker #0
So we can test our ideas before we risk any real money. That's a huge advantage. Yeah. But I imagine backtesting can get pretty complicated, especially when you're dealing with a global portfolio like this. Any tips for making the process more manageable?
Speaker #1
One key tip is to start simple. Don't try to overcomplicate things right from the get-go. Begin by testing the basic Ivy portfolio allocation with a 12-month momentum look-back and monthly rebalancing. See how that performs over various historical periods.
Speaker #0
Okay, start with the basics and then gradually refine from there. What other tips would you recommend?
Speaker #1
Another important tip is to pay attention to transaction costs.
Speaker #0
Right.
Speaker #1
Remember, every time you buy or sell an ETF, you'll incur brokerage commissions and possibly even bid-ask spreads. These costs can eat into your returns, especially if you're rebalancing frequently.
Speaker #0
That's a good point. So we need to strike a balance between staying nimble and keeping costs in check. Any other advice for our aspiring global momentum traders?
Speaker #1
One final tip I'd offer is to be patient. These momentum strategies are not about getting rich quick. They're about building a robust, well-tested process and letting it play out over time. There will be periods of underperformance, but if you stick with the plan, the odds are in your favor.
Speaker #0
So the key takeaways are to start simple, be mindful of costs, and be patient. Sounds like good advice for any investor, really.
Speaker #1
Absolutely. These are fundamental principles that can guide you through the ups and downs of the market. And remember, there's always more to learn. The world of algorithmic trading is con- constantly evolving with new strategies and technologies emerging all the time. So stay curious, keep experimenting, and never stop seeking knowledge.
Speaker #0
Well said. This has been a fantastic deep dive into sector momentum and global asset class rotation. We've covered a lot of ground, from the basic concepts to advanced strategies, from specific ETFs to sophisticated backtesting techniques.
Speaker #1
We've given our listeners a solid foundation to start exploring this exciting area of algorithmic trading. Who knows? Maybe one of our listeners will discover the next big momentum strategy.
Speaker #0
That would be fantastic. Well, that's all the time we have for today's deep dive. We hope you found it informative and inspiring.
Speaker #1
And as always, we encourage you to do your own research, understand the risks involved, and adapt these concepts to your own individual needs and goals.
Speaker #0
Thank you for tuning in to Papers with Backtest podcast. We hope today's episode gave you useful insights. Join us next time as we break down more research. And for more papers and backtest, find us at https.paperswithbacktest.com. Happy trading!

Chapters

Introduction to Sector Momentum Trading
0sec
Understanding Momentum and Rotational Trading
39sec
Faber's Methodology and Trading Rules
1min
Performance Results and Market Comparison
2min
Risk Management Techniques
4min
Diversifying Beyond U.S. Stocks
5min
Combining Hedging and Diversification
6min
Practical Considerations for Implementation
7min
Expanding to Global Asset Class Rotation
10min
Advanced Strategies and Final Thoughts
19min

Description

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Transcription

Speaker #0
Hello, welcome back to Papers with Backtest podcast. Today we dive into another algo trading research paper.
Speaker #1
We're going to be looking at a strategy from Maybane Faber's Relative Strength Strategies for Investing. You know, picking winning stocks is hard enough. Oh yeah. But this paper goes a step further. It explores applying momentum, not just to individual stocks, but to entire sectors of the U.S. stock market.
Speaker #0
Ah, sector momentum. I've heard that can be a powerful way to play the market rotation. Instead of trying to pick individual winners, you're betting on entire industries. So did Faber find that this approach actually works?
Speaker #1
He did. The results are pretty compelling. But before we get into those, let's make sure we're on the same page about what momentum and rotational trading actually mean.
Speaker #0
OK, let's break it down. When we talk about momentum, we're basically saying, hey, this asset, whether it's a stock or a whole sector, has been doing well recently. Let's ride that wave and hope it continues.
Speaker #1
Exactly. It's the whole idea of the trend is your friend. And rotational trading takes that concept and applies it to different sectors of the economy.
Speaker #0
Because not all sectors perform well at the same time, right? Yeah. Like during a tech boom, technology stocks might surge while energy lags behind. Then when oil prices spike, the energy sector could take the lead.
Speaker #1
Precisely. It's like a game of musical chairs with investors rotating into the sectors that are currently in favor. And Faber's research shows that this rotation can be quite powerful. profitable.
Speaker #0
So how did he actually test this out? What was his methodology?
Speaker #1
Well, he went way back in time. He used data on 10 different industry portfolios going all the way back to 1926. Wow,
Speaker #0
1926. That's almost a century of data. Must have taken ages to crunch all those numbers back then.
Speaker #1
It certainly wasn't as easy as it is today with our fancy computers and software, but that long history gives us a very robust data set, which is important when you're trying to draw statistically significant conclusions.
Speaker #0
Makes sense. So with those 10 sectors, how did he actually implement this momentum and rotation strategy? What were the specific trading rules?
Speaker #1
The strategy itself is remarkably simple. Each month, he ranked the sectors based on their trailing returns. Trailing returns, just so we're clear, are the returns an asset or strategy has generated over a specific period in the past.
Speaker #0
Got it. So if health care had the highest returns over the past three months, it would be at the top of the list, right? Then what? Do you buy all 10 sectors or just the top performers?
Speaker #1
That's where it gets interesting. He tested different portfolio sizes, buying the top one, two, or three sectors based on their trailing returns. And then, of course, you'd rebalance every month, selling the ones that fell out of favor and buying the new leaders.
Speaker #0
So you're constantly adjusting the portfolio, always chasing the hottest sectors. But did this actually lead to better returns than just buying and holding a diversified portfolio?
Speaker #1
Here's where it gets exciting. The relative strength strategy consistently outperformed the market over the entire period studied. And it wasn't just a fluke in one particular timeframe. It worked across various lookback periods for momentum, whether he used a one month, three month, or even a 12 month look back.
Speaker #0
Consistently outperforming the market over almost a century. I'm all ears. Give me the numbers. What kind of returns are we talking about?
Speaker #1
Well, the paper mentions eye performance of roughly three, 6% per year. Of course, that's before fees and taxes, which are real world factors any investor needs to consider.
Speaker #0
Three to six percent extra per year can really add up over time. That's the kind of edge that can make a big difference in the long run. Did you mention anything about how often this strategy actually beat the market?
Speaker #1
Yes. And this is the part that really stood out to me. It beat the buy and hold approach about 70 percent of the years tested. Think about that for a second. If you had a strategy that won seven out of 10 times. Yeah. Wouldn't you be pretty happy with those odds?
Speaker #0
I'd take those odds any day. It's not about being right all the time. It's about having an edge that tilts the scales in your favor over the long haul. Okay, so far, this sector momentum strategy is sounding pretty impressive. But I'm guessing it's not all sunshine and rainbows. What are some of the potential drawbacks we need to consider?
Speaker #1
You're right. No strategy is perfect. The main drawback here is that this system assumes you're fully invested in stocks at all times. which means it's still going to experience the ups and downs of the market as a whole.
Speaker #0
So when the market takes a dive, this portfolio is coming down with it. That sounds a bit unnerving. Did Faber offer any solutions to mitigate that risk?
Speaker #1
He did. He explored a couple of approaches to make the strategy more robust.
Speaker #0
Okay, I'm all ears. Let's talk risk management.
Speaker #1
The first solution involved a simple but effective hedging technique using a 10-month simple moving average, or SMA. You know that line on the chart that smooths out price fluctuations?
Speaker #0
I've seen those moving averages, but I've never really thought of them as a hedging tool. How does that work?
Speaker #1
Basically, when the S&P 500 drops below its 10-month SMA, it's a signal that the broad market is trending down. The strategy then goes to cash, essentially selling all the sector ETFs and moving to the sidelines until the market shows signs of recovery.
Speaker #0
So it's like a circuit breaker for the whole portfolio. When the market gets shaky, you hit the off switch and wait for the storm to pass. Did that actually improve the results?
Speaker #1
Significantly. This simple hedging technique substantially reduced volatility and drawdowns. The portfolio still made money, but it rode out the market storms much more smoothly.
Speaker #0
That's a pretty elegant solution. So what was the second approach?
Speaker #1
The second solution involved diversifying beyond just U.S. stocks.
Speaker #0
You know, you've mentioned a couple of times that different sectors perform differently at different points in the economic cycle. Right. But wouldn't the same logic apply to different types of assets altogether, like stocks versus bonds or even real estate and commodities?
Speaker #1
That's exactly the idea. Just like sectors rotate, different asset classes have their time in the sun. Faber actually explores this in more depth in his book, The Ivy Portfolio, where he adds global stocks, bonds, real estate through REITs and commodities to the mix.
Speaker #0
So by spreading your bets across different asset classes, you're not only chasing returns, but also trying to smooth out the ride.
Speaker #1
Precisely. And the beauty is you can still apply the same momentum and rotation principles to this broader portfolio. You'd be looking for which asset classes are showing the strongest recent performance and rotating into those.
Speaker #0
OK, so we have two potential solutions here hedging with a moving average to protect against downturns and diversifying across different asset classes to spread the risk. Did the paper look at combining these two approaches?
Speaker #1
Now, that's where things get really interesting and a bit more advanced. It's a topic worthy of its own deep dive in the future. But I can tell you that combining both hedging and diversifying led to even better risk adjusted returns.
Speaker #0
Ooh, a teaser for a future episode. I like it. OK, so we've got these strategies in there. impressive back-tested results. But let's be real for a second. This research was all done using historical data. How much confidence can we really have that these strategies will work in the future?
Speaker #1
That's the eternal question in investing, isn't it? Past performance is never a guarantee of future results. But the fact that this strategy has worked over such a long period, encompassing various market cycles and economic upheavals, does lend it a degree of credibility. It suggests there might be something fundamentally sound about following momentum and rotating between sectors or asset classes.
Speaker #0
I see what you mean. A track record spanning almost a century is hard to ignore. It's not like we're talking about a few lucky years in a bull market. What else should we consider when thinking about how to actually put these strategies into practice?
Speaker #1
One key difference between back then and now is the ease of implementation. Back in the 1920s, trying to trade all these sectors would have been incredibly costly and complex. Today, thanks to ETFs, It's much simpler and cheaper to get exposure to specific sectors or asset classes.
Speaker #0
ETFs have been a game changer for this type of strategy. Low costs, easy to trade. It's like building blocks for your portfolio.
Speaker #1
Exactly. And another practical consideration is taxes. These strategies involve a fair amount of buying and selling, which can trigger tactical events. So it's generally a good idea to use them in tax-advantaged accounts like IRAs or 401ks. That way, you can keep more of your... your profits.
Speaker #0
Solid advice. Tax efficiency is crucial, especially for strategies with regular rebalancing. Well, this has been a fascinating deep dive into sector momentum. We've covered the basic idea, the research, the results, and even some practical considerations for putting it into action.
Speaker #1
It's really a testament to the power of relatively simple quantitative strategies. By systematically following momentum and rotating between sectors or asset classes, investors can potentially outperform the market in the long run.
Speaker #0
Who doesn't love the sound of that? But as always, we encourage our listeners to do their own research, understand the risks involved, and tailor any strategy to their own individual needs and goals.
Speaker #1
Absolutely. Every investor is different. What works for one person might not work for another. Critical thinking and informed decision making are essential in the world of investing. Don't just blindly follow any strategy. Make sure you understand why it works and if it's right for you.
Speaker #0
Well said. Any final thoughts for our listeners before we wrap up part one of this deep...
Speaker #1
You know, what's really striking about this research is how it highlights the cyclical nature of markets. Sectors and asset classes inevitably go through periods of outperformance and underperformance. The key is to have a systematic way to identify those shifts and position yourself accordingly.
Speaker #0
So the takeaway here is to think beyond individual stocks. Zoom out and consider the broader trends affecting different parts of the economy and different asset classes. Use momentum and rotation to ride those waves. That's some insightful stuff to chew on. We'll pick up this conversation in part two, where we'll delve deeper into the practical aspects of implementing these strategies.
Speaker #1
We'll be exploring specific ETFs, trading platforms, and even backtesting tools to help you put these ideas into practice.
Speaker #0
Sounds like a plan. We'll see you in part two.
Speaker #1
Welcome back to part two of our deep dive into sector momentum.
Speaker #0
We left off talking about how much easier it is to implement these strategies today, thanks to ETFs.
Speaker #1
Right. ETFs have really democratized access to different sectors and asset classes. If you're trying to do this decades ago, you would have needed to buy and sell tons of individual stocks every month.
Speaker #0
Oh,
Speaker #1
wow. Can you imagine the trading commissions?
Speaker #0
Yikes. That sounds like a logistical nightmare, not to mention expensive. But with ETFs, you can buy a whole basket of stocks in a specific sector with just one trade. So let's get specific. If someone wanted to build a sector rotation strategy based on Faber's research, what are some ETFs they could consider?
Speaker #1
Well, you have a lot of choices these days, but luckily for us, the paper looks at 10 broad sectors of the US economy. You can easily find an ETF for each.
Speaker #0
10 sectors, that's a good starting point. I'm ready to build my momentum machine. Hit me with those tickers.
Speaker #1
All right, let's start with technology. A very popular ETF for that sector is the Technology Select Sector SPDR Fund, ticker symbol XLK. It holds a bunch of familiar names like Apple, Microsoft, NVIDIA, and so on.
Speaker #0
XLK, that's one I've heard of. What about healthcare? Always a big sector, especially as the population ages.
Speaker #1
For healthcare, a good option is the Healthcare Select Sector SPDR Fund, ticker symbol XLV. This one covers everything. From pharmaceuticals to medical equipment and health insurance companies.
Speaker #0
So XLK for tech, XLV for health care. Yeah. Any others you'd recommend?
Speaker #1
Let's see. We should probably include consumer staples since people always need things like food and household products regardless of the economy. The consumer staples select sector SPDR fund, ticker symbol XLP, would be a good choice for that. It holds companies like Procter & Gamble, Coca-Cola, Walmart, and those types of businesses.
Speaker #0
XLP. Got it. Yeah. So we've got tech. healthcare and consumer staples. What if you're feeling bullish on energy or maybe the financial sector?
Speaker #1
If you're looking at energy, there's the Energy Select Sector SPDR Fund, ticker symbol XLE. It tracks the performance of oil and gas companies as well as energy equipment and services providers.
Speaker #0
Interesting. So even if you don't want to pick individual oil stocks, you can still get exposure to that sector through XLE. And what about financials?
Speaker #1
For financials, you have the Financial Select Sector SPDR Fund, ticker symbol XLF. It includes a wide range of banks, insurance companies, and other financial institutions.
Speaker #0
XLF, got it. Okay, that's five sectors covered. I'm assuming there are ETFs for the remaining five as well.
Speaker #1
Absolutely. You can find ETFs for industrials, materials, utilities, real estate, and consumer discretionary, covering pretty much every corner of the market. We could spend the whole episode just listing ETFs, but I think you get the idea.
Speaker #0
Yeah, I think our listeners are probably getting ticker overload by now. But the point is, there's an ETF for just about anything these days. So let's say we've picked our 10-sector ETS. Now we need to figure out when to buy and sell them based on momentum. Do we need some fancy software to do all those calculations?
Speaker #1
You could certainly build your own custom trading algorithms if you have the programming skills. Right. But for most people, there are easier ways. Several online platforms offer tools specifically designed for backtesting and implementing momentum strategies.
Speaker #0
Backtesting. That sounds intriguing. You've mentioned it a couple of times now. Can you explain what that is and why it's so important?
Speaker #1
Think of backtesting like a flight simulator for your trading strategy. Okay. It allows you to test your ideas using historical data so you can see how they would have performed without actually risking any real money.
Speaker #0
Ah, so it's like a practice run before you go live with your strategy.
Speaker #1
Exactly. You can plug in your trading rules like the momentum lookback periods and portfolio size. The software will simulate how the strategy would have performed over different market conditions.
Speaker #0
Okay, so you can see if your brilliant idea actually works or if it would have blown up your account five years ago. Sounds pretty useful. Are there any particular backtesting platforms you'd recommend?
Speaker #1
There are a few popular ones out there. TradingView is great for its charting capabilities and has a pretty robust backtesting feature. Portfolio Visualizer is another good option, and it's free to use, which is always a plus. Yeah. Some brokerage accounts even have backtesting tools built into their platforms.
Speaker #0
So there are options for every budget and level of expertise. Great. So we've chosen our ETFs. We've backtested our momentum strategy. We're feeling confident. We're ready to trade, right? Just need to open a brokerage account and start placing orders.
Speaker #1
Well, hold your horses. There are a few more things to consider before you jump in headfirst. You don't want to go all in on a strategy without understanding the risks and practicalities.
Speaker #0
Alright, let's talk risk management. What else do we need to be thinking about?
Speaker #1
First of all, not all brokerage accounts are created equal, especially when it comes to trading ETFs. You'll want to find one that has low commissions because we'll be doing a fair bit of buying and selling with this strategy. You also want a good selection of ETFs to choose from and a platform that's easy to use for placing trades and monitoring your portfolio.
Speaker #0
Low costs and ease of use are definitely important. Anything else?
Speaker #1
The most important thing is to know your own risk tolerance. Right. Remember, even though these strategies can potentially beat the market, there are no guarantees. You need to be comfortable with the fact that the market can be volatile and your portfolio will experience ups and downs along the way.
Speaker #0
So don't bet the farm just because you had some good backtest results.
Speaker #1
Exactly. Start small, test the waters with an amount you're comfortable losing. and gradually increase your position size as you gain more confidence and experience.
Speaker #0
That's sound advice. And what about those hedging techniques we discussed earlier? How would someone actually put those into practice?
Speaker #1
Let's revisit that 10-month SMA approach. It's actually pretty straightforward to implement. Most charting platforms will let you add a moving average to your charts. You can also easily track it in a spreadsheet if you're so inclined.
Speaker #0
Okay, so I've got my chart, I've got my moving average line, now what?
Speaker #1
When the S&P 500 closes below its 10-month SMA, that's your signal to sell your sector ETFs and move to cash. You can hold your cash in a money market fund or a short-term treasury ETF, something that's considered very low risk.
Speaker #0
It's like a safety net for your portfolio. When the market starts to look shaky, you step back and wait for things to improve.
Speaker #1
Exactly. You're not trying to time the market perfectly. You're just trying to avoid the worst of the downturns. Of course, there are other hedging strategies you could consider, like using options or inverse ETFs, but those can be more complex and have their own risks.
Speaker #0
Let's not overwhelm our listeners with too much complexity all at once. Right. Better to start simple and master the basics. Speaking of basics, you know one thing that's often overlooked? The psychological side of trading.
Speaker #1
You mean how our emotions can get in the way of making rational decisions?
Speaker #0
Exactly. Fear and greed are powerful forces. and it's easy to get swept up in the hype or panic of the market. How do we avoid letting our emotions sabotage our strategy?
Speaker #1
That's where having a well-defined plan comes in. Write down your trading rules, stick to them, and don't second guess yourself. You're not going to be right all the time, and that's okay. The key is to have a process you trust and follow it consistently.
Speaker #0
So discipline and emotional control are just as important as the technical aspects of the strategy.
Speaker #1
Absolutely. And remember, this is a long-term game. You're not going to get rich quick. Focus on building a robust, well-tested strategy and let the power of compounding work its magic over time.
Speaker #0
Right. Patience and consistency are key in investing. OK, we've covered a lot of ground in this part, too. We've talked about ETFs, backtesting platforms, brokerage accounts, risk management and even the psychology of trading. Anything else we should address before we wrap up this part?
Speaker #1
You know, one thing we should emphasize is that this research is just a starting point. It gives us a framework to think about, but it's not a plug and play system. Every investor needs to adapt these concepts to their own situation and risk tolerance.
Speaker #0
Right. There's no one size fits all solution in investing. You need to do your own research, understand the risks involved, and tailor the strategy to your own individual needs and goals.
Speaker #1
Exactly. And that's where the real fun begins. You can take these concepts and run with them. You can experiment with different ETFs, different look. look back periods, different hedging techniques. You can even combine sector momentum with other strategies. The possibilities are endless.
Speaker #0
So it's about taking what we've learned, putting it into practice, and constantly learning and improving along the way.
Speaker #1
Absolutely. That's the beauty of algorithmic trading. It's a continuous process of learning, adapting, and optimizing. And who knows, you might even discover some new insights that Faber himself didn't consider.
Speaker #0
Well, that's an inspiring thought. So for our listeners who are ready to take the next step, what's in store for part three of our deep dive?
Speaker #1
In the final part, we'll be diving into even more advanced concepts. We'll explore how to combine sector momentum with a global asset class rotation, taking the IV portfolio concept to the next level. We'll also touch on some more sophisticated backtesting techniques and resources.
Speaker #0
Sounds like we'll be taking this momentum strategy to a whole new level. Can't wait. We'll see you in part three. Welcome back to part three of our deep dive into sector momentum.
Speaker #1
In this final part, we're going to expand our horizons beyond just U.S. stocks.
Speaker #0
Okay.
Speaker #1
Remember how we talked about Faber's Ivy portfolio concept? Yeah. We're going to see how we can apply the same momentum and rotation principles to a globally diversified portfolio.
Speaker #0
Okay, so instead of just rotating between 10 sectors of the U.S. stock market, we're now talking about a much broader range of assets. We've got U.S. stocks. international stocks, bonds, real estate, commodities. It's like we're playing a bigger game of musical chairs now.
Speaker #1
Exactly. We're casting a wider net looking for opportunities wherever they might arise. And the good news is the ETF universe has exploded in recent years. Oh, wow. You can now find an ETF for pretty much every imaginable asset class.
Speaker #0
So if I'm feeling bullish on Brazilian bonds or Vietnamese real estate, there's probably an ETF for that.
Speaker #1
Probably. But let's focus on some of the core asset classes that Faber includes in his Ivy portfolio. For broad exposure to global stocks, you have ETFs like the Vanguard Total World Stock ETF, ticker symbol VT. VT.
Speaker #0
Got it. That sounds like a simple way to get exposure to thousands of stocks across the globe. What about bonds? Any ETFs you'd recommend for that asset class?
Speaker #1
For a broad-based bond portfolio, a good starting point would be the Vanguard Total Bond Market ETF, ticker symbol BND. This one holds a mix of U.S. government bonds, corporate bonds, and mortgage-backed securities.
Speaker #0
BND. OK. So we've got VT for global stocks, BND for bonds. We're starting to build our global momentum machine. What's next?
Speaker #1
Well, we can't forget about real estate. A popular ETF for that is the Real Estate Select Sector SPDR Fund, ticker symbol XLRE. This one mainly holds real estate investment trusts or REITs, which own and manage various types of properties.
Speaker #0
That's LRE for real estate. Makes sense. And I'm guessing we'll need an ETF for commodities too.
Speaker #1
Of course. You have a few options there. One is the Invesco DB Commodity Index Tracking Fund, ticker symbol DBC. This ETF tracks a broad basket of commodities, including energy, metals, and agricultural products.
Speaker #0
Wow, so many ETFs to choose from. It's amazing how easy it is to build a truly diversified portfolio these days. But I have a feeling the momentum calculations and rotation decisions might get a bit more complicated when you're dealing with so many different asset classes.
Speaker #1
That's where our trusty backtesting tools come in. Remember those? Yeah. They can help us analyze the historical performance of these various asset classes and see which ones have tended to exhibit the strongest momentum.
Speaker #0
Right. We can use backtesting to figure out not only which asset classes to include, but also how to allocate our portfolio and how often to rebalance.
Speaker #1
Exactly. You can experiment with different momentum lookback periods, different portfolio weights and different rebalancing frequencies. The software will simulate how those decisions would have impacted your returns over time.
Speaker #0
So we can test our ideas before we risk any real money. That's a huge advantage. Yeah. But I imagine backtesting can get pretty complicated, especially when you're dealing with a global portfolio like this. Any tips for making the process more manageable?
Speaker #1
One key tip is to start simple. Don't try to overcomplicate things right from the get-go. Begin by testing the basic Ivy portfolio allocation with a 12-month momentum look-back and monthly rebalancing. See how that performs over various historical periods.
Speaker #0
Okay, start with the basics and then gradually refine from there. What other tips would you recommend?
Speaker #1
Another important tip is to pay attention to transaction costs.
Speaker #0
Right.
Speaker #1
Remember, every time you buy or sell an ETF, you'll incur brokerage commissions and possibly even bid-ask spreads. These costs can eat into your returns, especially if you're rebalancing frequently.
Speaker #0
That's a good point. So we need to strike a balance between staying nimble and keeping costs in check. Any other advice for our aspiring global momentum traders?
Speaker #1
One final tip I'd offer is to be patient. These momentum strategies are not about getting rich quick. They're about building a robust, well-tested process and letting it play out over time. There will be periods of underperformance, but if you stick with the plan, the odds are in your favor.
Speaker #0
So the key takeaways are to start simple, be mindful of costs, and be patient. Sounds like good advice for any investor, really.
Speaker #1
Absolutely. These are fundamental principles that can guide you through the ups and downs of the market. And remember, there's always more to learn. The world of algorithmic trading is con- constantly evolving with new strategies and technologies emerging all the time. So stay curious, keep experimenting, and never stop seeking knowledge.
Speaker #0
Well said. This has been a fantastic deep dive into sector momentum and global asset class rotation. We've covered a lot of ground, from the basic concepts to advanced strategies, from specific ETFs to sophisticated backtesting techniques.
Speaker #1
We've given our listeners a solid foundation to start exploring this exciting area of algorithmic trading. Who knows? Maybe one of our listeners will discover the next big momentum strategy.
Speaker #0
That would be fantastic. Well, that's all the time we have for today's deep dive. We hope you found it informative and inspiring.
Speaker #1
And as always, we encourage you to do your own research, understand the risks involved, and adapt these concepts to your own individual needs and goals.
Speaker #0
Thank you for tuning in to Papers with Backtest podcast. We hope today's episode gave you useful insights. Join us next time as we break down more research. And for more papers and backtest, find us at https.paperswithbacktest.com. Happy trading!

Chapters

Introduction to Sector Momentum Trading
0sec
Understanding Momentum and Rotational Trading
39sec
Faber's Methodology and Trading Rules
1min
Performance Results and Market Comparison
2min
Risk Management Techniques
4min
Diversifying Beyond U.S. Stocks
5min
Combining Hedging and Diversification
6min
Practical Considerations for Implementation
7min
Expanding to Global Asset Class Rotation
10min
Advanced Strategies and Final Thoughts
19min

Embed

Introduction to Sector Momentum Trading

0sec

Understanding Momentum and Rotational Trading

39sec

Faber's Methodology and Trading Rules

1min

Performance Results and Market Comparison

2min

Risk Management Techniques

4min

Diversifying Beyond U.S. Stocks

5min

Combining Hedging and Diversification

6min

Practical Considerations for Implementation

7min

Expanding to Global Asset Class Rotation

10min

Advanced Strategies and Final Thoughts

19min

Transcription

Speaker #0
Hello, welcome back to Papers with Backtest podcast. Today we dive into another algo trading research paper.
Speaker #1
We're going to be looking at a strategy from Maybane Faber's Relative Strength Strategies for Investing. You know, picking winning stocks is hard enough. Oh yeah. But this paper goes a step further. It explores applying momentum, not just to individual stocks, but to entire sectors of the U.S. stock market.
Speaker #0
Ah, sector momentum. I've heard that can be a powerful way to play the market rotation. Instead of trying to pick individual winners, you're betting on entire industries. So did Faber find that this approach actually works?
Speaker #1
He did. The results are pretty compelling. But before we get into those, let's make sure we're on the same page about what momentum and rotational trading actually mean.
Speaker #0
OK, let's break it down. When we talk about momentum, we're basically saying, hey, this asset, whether it's a stock or a whole sector, has been doing well recently. Let's ride that wave and hope it continues.
Speaker #1
Exactly. It's the whole idea of the trend is your friend. And rotational trading takes that concept and applies it to different sectors of the economy.
Speaker #0
Because not all sectors perform well at the same time, right? Yeah. Like during a tech boom, technology stocks might surge while energy lags behind. Then when oil prices spike, the energy sector could take the lead.
Speaker #1
Precisely. It's like a game of musical chairs with investors rotating into the sectors that are currently in favor. And Faber's research shows that this rotation can be quite powerful. profitable.
Speaker #0
So how did he actually test this out? What was his methodology?
Speaker #1
Well, he went way back in time. He used data on 10 different industry portfolios going all the way back to 1926. Wow,
Speaker #0
1926. That's almost a century of data. Must have taken ages to crunch all those numbers back then.
Speaker #1
It certainly wasn't as easy as it is today with our fancy computers and software, but that long history gives us a very robust data set, which is important when you're trying to draw statistically significant conclusions.
Speaker #0
Makes sense. So with those 10 sectors, how did he actually implement this momentum and rotation strategy? What were the specific trading rules?
Speaker #1
The strategy itself is remarkably simple. Each month, he ranked the sectors based on their trailing returns. Trailing returns, just so we're clear, are the returns an asset or strategy has generated over a specific period in the past.
Speaker #0
Got it. So if health care had the highest returns over the past three months, it would be at the top of the list, right? Then what? Do you buy all 10 sectors or just the top performers?
Speaker #1
That's where it gets interesting. He tested different portfolio sizes, buying the top one, two, or three sectors based on their trailing returns. And then, of course, you'd rebalance every month, selling the ones that fell out of favor and buying the new leaders.
Speaker #0
So you're constantly adjusting the portfolio, always chasing the hottest sectors. But did this actually lead to better returns than just buying and holding a diversified portfolio?
Speaker #1
Here's where it gets exciting. The relative strength strategy consistently outperformed the market over the entire period studied. And it wasn't just a fluke in one particular timeframe. It worked across various lookback periods for momentum, whether he used a one month, three month, or even a 12 month look back.
Speaker #0
Consistently outperforming the market over almost a century. I'm all ears. Give me the numbers. What kind of returns are we talking about?
Speaker #1
Well, the paper mentions eye performance of roughly three, 6% per year. Of course, that's before fees and taxes, which are real world factors any investor needs to consider.
Speaker #0
Three to six percent extra per year can really add up over time. That's the kind of edge that can make a big difference in the long run. Did you mention anything about how often this strategy actually beat the market?
Speaker #1
Yes. And this is the part that really stood out to me. It beat the buy and hold approach about 70 percent of the years tested. Think about that for a second. If you had a strategy that won seven out of 10 times. Yeah. Wouldn't you be pretty happy with those odds?
Speaker #0
I'd take those odds any day. It's not about being right all the time. It's about having an edge that tilts the scales in your favor over the long haul. Okay, so far, this sector momentum strategy is sounding pretty impressive. But I'm guessing it's not all sunshine and rainbows. What are some of the potential drawbacks we need to consider?
Speaker #1
You're right. No strategy is perfect. The main drawback here is that this system assumes you're fully invested in stocks at all times. which means it's still going to experience the ups and downs of the market as a whole.
Speaker #0
So when the market takes a dive, this portfolio is coming down with it. That sounds a bit unnerving. Did Faber offer any solutions to mitigate that risk?
Speaker #1
He did. He explored a couple of approaches to make the strategy more robust.
Speaker #0
Okay, I'm all ears. Let's talk risk management.
Speaker #1
The first solution involved a simple but effective hedging technique using a 10-month simple moving average, or SMA. You know that line on the chart that smooths out price fluctuations?
Speaker #0
I've seen those moving averages, but I've never really thought of them as a hedging tool. How does that work?
Speaker #1
Basically, when the S&P 500 drops below its 10-month SMA, it's a signal that the broad market is trending down. The strategy then goes to cash, essentially selling all the sector ETFs and moving to the sidelines until the market shows signs of recovery.
Speaker #0
So it's like a circuit breaker for the whole portfolio. When the market gets shaky, you hit the off switch and wait for the storm to pass. Did that actually improve the results?
Speaker #1
Significantly. This simple hedging technique substantially reduced volatility and drawdowns. The portfolio still made money, but it rode out the market storms much more smoothly.
Speaker #0
That's a pretty elegant solution. So what was the second approach?
Speaker #1
The second solution involved diversifying beyond just U.S. stocks.
Speaker #0
You know, you've mentioned a couple of times that different sectors perform differently at different points in the economic cycle. Right. But wouldn't the same logic apply to different types of assets altogether, like stocks versus bonds or even real estate and commodities?
Speaker #1
That's exactly the idea. Just like sectors rotate, different asset classes have their time in the sun. Faber actually explores this in more depth in his book, The Ivy Portfolio, where he adds global stocks, bonds, real estate through REITs and commodities to the mix.
Speaker #0
So by spreading your bets across different asset classes, you're not only chasing returns, but also trying to smooth out the ride.
Speaker #1
Precisely. And the beauty is you can still apply the same momentum and rotation principles to this broader portfolio. You'd be looking for which asset classes are showing the strongest recent performance and rotating into those.
Speaker #0
OK, so we have two potential solutions here hedging with a moving average to protect against downturns and diversifying across different asset classes to spread the risk. Did the paper look at combining these two approaches?
Speaker #1
Now, that's where things get really interesting and a bit more advanced. It's a topic worthy of its own deep dive in the future. But I can tell you that combining both hedging and diversifying led to even better risk adjusted returns.
Speaker #0
Ooh, a teaser for a future episode. I like it. OK, so we've got these strategies in there. impressive back-tested results. But let's be real for a second. This research was all done using historical data. How much confidence can we really have that these strategies will work in the future?
Speaker #1
That's the eternal question in investing, isn't it? Past performance is never a guarantee of future results. But the fact that this strategy has worked over such a long period, encompassing various market cycles and economic upheavals, does lend it a degree of credibility. It suggests there might be something fundamentally sound about following momentum and rotating between sectors or asset classes.
Speaker #0
I see what you mean. A track record spanning almost a century is hard to ignore. It's not like we're talking about a few lucky years in a bull market. What else should we consider when thinking about how to actually put these strategies into practice?
Speaker #1
One key difference between back then and now is the ease of implementation. Back in the 1920s, trying to trade all these sectors would have been incredibly costly and complex. Today, thanks to ETFs, It's much simpler and cheaper to get exposure to specific sectors or asset classes.
Speaker #0
ETFs have been a game changer for this type of strategy. Low costs, easy to trade. It's like building blocks for your portfolio.
Speaker #1
Exactly. And another practical consideration is taxes. These strategies involve a fair amount of buying and selling, which can trigger tactical events. So it's generally a good idea to use them in tax-advantaged accounts like IRAs or 401ks. That way, you can keep more of your... your profits.
Speaker #0
Solid advice. Tax efficiency is crucial, especially for strategies with regular rebalancing. Well, this has been a fascinating deep dive into sector momentum. We've covered the basic idea, the research, the results, and even some practical considerations for putting it into action.
Speaker #1
It's really a testament to the power of relatively simple quantitative strategies. By systematically following momentum and rotating between sectors or asset classes, investors can potentially outperform the market in the long run.
Speaker #0
Who doesn't love the sound of that? But as always, we encourage our listeners to do their own research, understand the risks involved, and tailor any strategy to their own individual needs and goals.
Speaker #1
Absolutely. Every investor is different. What works for one person might not work for another. Critical thinking and informed decision making are essential in the world of investing. Don't just blindly follow any strategy. Make sure you understand why it works and if it's right for you.
Speaker #0
Well said. Any final thoughts for our listeners before we wrap up part one of this deep...
Speaker #1
You know, what's really striking about this research is how it highlights the cyclical nature of markets. Sectors and asset classes inevitably go through periods of outperformance and underperformance. The key is to have a systematic way to identify those shifts and position yourself accordingly.
Speaker #0
So the takeaway here is to think beyond individual stocks. Zoom out and consider the broader trends affecting different parts of the economy and different asset classes. Use momentum and rotation to ride those waves. That's some insightful stuff to chew on. We'll pick up this conversation in part two, where we'll delve deeper into the practical aspects of implementing these strategies.
Speaker #1
We'll be exploring specific ETFs, trading platforms, and even backtesting tools to help you put these ideas into practice.
Speaker #0
Sounds like a plan. We'll see you in part two.
Speaker #1
Welcome back to part two of our deep dive into sector momentum.
Speaker #0
We left off talking about how much easier it is to implement these strategies today, thanks to ETFs.
Speaker #1
Right. ETFs have really democratized access to different sectors and asset classes. If you're trying to do this decades ago, you would have needed to buy and sell tons of individual stocks every month.
Speaker #0
Oh,
Speaker #1
wow. Can you imagine the trading commissions?
Speaker #0
Yikes. That sounds like a logistical nightmare, not to mention expensive. But with ETFs, you can buy a whole basket of stocks in a specific sector with just one trade. So let's get specific. If someone wanted to build a sector rotation strategy based on Faber's research, what are some ETFs they could consider?
Speaker #1
Well, you have a lot of choices these days, but luckily for us, the paper looks at 10 broad sectors of the US economy. You can easily find an ETF for each.
Speaker #0
10 sectors, that's a good starting point. I'm ready to build my momentum machine. Hit me with those tickers.
Speaker #1
All right, let's start with technology. A very popular ETF for that sector is the Technology Select Sector SPDR Fund, ticker symbol XLK. It holds a bunch of familiar names like Apple, Microsoft, NVIDIA, and so on.
Speaker #0
XLK, that's one I've heard of. What about healthcare? Always a big sector, especially as the population ages.
Speaker #1
For healthcare, a good option is the Healthcare Select Sector SPDR Fund, ticker symbol XLV. This one covers everything. From pharmaceuticals to medical equipment and health insurance companies.
Speaker #0
So XLK for tech, XLV for health care. Yeah. Any others you'd recommend?
Speaker #1
Let's see. We should probably include consumer staples since people always need things like food and household products regardless of the economy. The consumer staples select sector SPDR fund, ticker symbol XLP, would be a good choice for that. It holds companies like Procter & Gamble, Coca-Cola, Walmart, and those types of businesses.
Speaker #0
XLP. Got it. Yeah. So we've got tech. healthcare and consumer staples. What if you're feeling bullish on energy or maybe the financial sector?
Speaker #1
If you're looking at energy, there's the Energy Select Sector SPDR Fund, ticker symbol XLE. It tracks the performance of oil and gas companies as well as energy equipment and services providers.
Speaker #0
Interesting. So even if you don't want to pick individual oil stocks, you can still get exposure to that sector through XLE. And what about financials?
Speaker #1
For financials, you have the Financial Select Sector SPDR Fund, ticker symbol XLF. It includes a wide range of banks, insurance companies, and other financial institutions.
Speaker #0
XLF, got it. Okay, that's five sectors covered. I'm assuming there are ETFs for the remaining five as well.
Speaker #1
Absolutely. You can find ETFs for industrials, materials, utilities, real estate, and consumer discretionary, covering pretty much every corner of the market. We could spend the whole episode just listing ETFs, but I think you get the idea.
Speaker #0
Yeah, I think our listeners are probably getting ticker overload by now. But the point is, there's an ETF for just about anything these days. So let's say we've picked our 10-sector ETS. Now we need to figure out when to buy and sell them based on momentum. Do we need some fancy software to do all those calculations?
Speaker #1
You could certainly build your own custom trading algorithms if you have the programming skills. Right. But for most people, there are easier ways. Several online platforms offer tools specifically designed for backtesting and implementing momentum strategies.
Speaker #0
Backtesting. That sounds intriguing. You've mentioned it a couple of times now. Can you explain what that is and why it's so important?
Speaker #1
Think of backtesting like a flight simulator for your trading strategy. Okay. It allows you to test your ideas using historical data so you can see how they would have performed without actually risking any real money.
Speaker #0
Ah, so it's like a practice run before you go live with your strategy.
Speaker #1
Exactly. You can plug in your trading rules like the momentum lookback periods and portfolio size. The software will simulate how the strategy would have performed over different market conditions.
Speaker #0
Okay, so you can see if your brilliant idea actually works or if it would have blown up your account five years ago. Sounds pretty useful. Are there any particular backtesting platforms you'd recommend?
Speaker #1
There are a few popular ones out there. TradingView is great for its charting capabilities and has a pretty robust backtesting feature. Portfolio Visualizer is another good option, and it's free to use, which is always a plus. Yeah. Some brokerage accounts even have backtesting tools built into their platforms.
Speaker #0
So there are options for every budget and level of expertise. Great. So we've chosen our ETFs. We've backtested our momentum strategy. We're feeling confident. We're ready to trade, right? Just need to open a brokerage account and start placing orders.
Speaker #1
Well, hold your horses. There are a few more things to consider before you jump in headfirst. You don't want to go all in on a strategy without understanding the risks and practicalities.
Speaker #0
Alright, let's talk risk management. What else do we need to be thinking about?
Speaker #1
First of all, not all brokerage accounts are created equal, especially when it comes to trading ETFs. You'll want to find one that has low commissions because we'll be doing a fair bit of buying and selling with this strategy. You also want a good selection of ETFs to choose from and a platform that's easy to use for placing trades and monitoring your portfolio.
Speaker #0
Low costs and ease of use are definitely important. Anything else?
Speaker #1
The most important thing is to know your own risk tolerance. Right. Remember, even though these strategies can potentially beat the market, there are no guarantees. You need to be comfortable with the fact that the market can be volatile and your portfolio will experience ups and downs along the way.
Speaker #0
So don't bet the farm just because you had some good backtest results.
Speaker #1
Exactly. Start small, test the waters with an amount you're comfortable losing. and gradually increase your position size as you gain more confidence and experience.
Speaker #0
That's sound advice. And what about those hedging techniques we discussed earlier? How would someone actually put those into practice?
Speaker #1
Let's revisit that 10-month SMA approach. It's actually pretty straightforward to implement. Most charting platforms will let you add a moving average to your charts. You can also easily track it in a spreadsheet if you're so inclined.
Speaker #0
Okay, so I've got my chart, I've got my moving average line, now what?
Speaker #1
When the S&P 500 closes below its 10-month SMA, that's your signal to sell your sector ETFs and move to cash. You can hold your cash in a money market fund or a short-term treasury ETF, something that's considered very low risk.
Speaker #0
It's like a safety net for your portfolio. When the market starts to look shaky, you step back and wait for things to improve.
Speaker #1
Exactly. You're not trying to time the market perfectly. You're just trying to avoid the worst of the downturns. Of course, there are other hedging strategies you could consider, like using options or inverse ETFs, but those can be more complex and have their own risks.
Speaker #0
Let's not overwhelm our listeners with too much complexity all at once. Right. Better to start simple and master the basics. Speaking of basics, you know one thing that's often overlooked? The psychological side of trading.
Speaker #1
You mean how our emotions can get in the way of making rational decisions?
Speaker #0
Exactly. Fear and greed are powerful forces. and it's easy to get swept up in the hype or panic of the market. How do we avoid letting our emotions sabotage our strategy?
Speaker #1
That's where having a well-defined plan comes in. Write down your trading rules, stick to them, and don't second guess yourself. You're not going to be right all the time, and that's okay. The key is to have a process you trust and follow it consistently.
Speaker #0
So discipline and emotional control are just as important as the technical aspects of the strategy.
Speaker #1
Absolutely. And remember, this is a long-term game. You're not going to get rich quick. Focus on building a robust, well-tested strategy and let the power of compounding work its magic over time.
Speaker #0
Right. Patience and consistency are key in investing. OK, we've covered a lot of ground in this part, too. We've talked about ETFs, backtesting platforms, brokerage accounts, risk management and even the psychology of trading. Anything else we should address before we wrap up this part?
Speaker #1
You know, one thing we should emphasize is that this research is just a starting point. It gives us a framework to think about, but it's not a plug and play system. Every investor needs to adapt these concepts to their own situation and risk tolerance.
Speaker #0
Right. There's no one size fits all solution in investing. You need to do your own research, understand the risks involved, and tailor the strategy to your own individual needs and goals.
Speaker #1
Exactly. And that's where the real fun begins. You can take these concepts and run with them. You can experiment with different ETFs, different look. look back periods, different hedging techniques. You can even combine sector momentum with other strategies. The possibilities are endless.
Speaker #0
So it's about taking what we've learned, putting it into practice, and constantly learning and improving along the way.
Speaker #1
Absolutely. That's the beauty of algorithmic trading. It's a continuous process of learning, adapting, and optimizing. And who knows, you might even discover some new insights that Faber himself didn't consider.
Speaker #0
Well, that's an inspiring thought. So for our listeners who are ready to take the next step, what's in store for part three of our deep dive?
Speaker #1
In the final part, we'll be diving into even more advanced concepts. We'll explore how to combine sector momentum with a global asset class rotation, taking the IV portfolio concept to the next level. We'll also touch on some more sophisticated backtesting techniques and resources.
Speaker #0
Sounds like we'll be taking this momentum strategy to a whole new level. Can't wait. We'll see you in part three. Welcome back to part three of our deep dive into sector momentum.
Speaker #1
In this final part, we're going to expand our horizons beyond just U.S. stocks.
Speaker #0
Okay.
Speaker #1
Remember how we talked about Faber's Ivy portfolio concept? Yeah. We're going to see how we can apply the same momentum and rotation principles to a globally diversified portfolio.
Speaker #0
Okay, so instead of just rotating between 10 sectors of the U.S. stock market, we're now talking about a much broader range of assets. We've got U.S. stocks. international stocks, bonds, real estate, commodities. It's like we're playing a bigger game of musical chairs now.
Speaker #1
Exactly. We're casting a wider net looking for opportunities wherever they might arise. And the good news is the ETF universe has exploded in recent years. Oh, wow. You can now find an ETF for pretty much every imaginable asset class.
Speaker #0
So if I'm feeling bullish on Brazilian bonds or Vietnamese real estate, there's probably an ETF for that.
Speaker #1
Probably. But let's focus on some of the core asset classes that Faber includes in his Ivy portfolio. For broad exposure to global stocks, you have ETFs like the Vanguard Total World Stock ETF, ticker symbol VT. VT.
Speaker #0
Got it. That sounds like a simple way to get exposure to thousands of stocks across the globe. What about bonds? Any ETFs you'd recommend for that asset class?
Speaker #1
For a broad-based bond portfolio, a good starting point would be the Vanguard Total Bond Market ETF, ticker symbol BND. This one holds a mix of U.S. government bonds, corporate bonds, and mortgage-backed securities.
Speaker #0
BND. OK. So we've got VT for global stocks, BND for bonds. We're starting to build our global momentum machine. What's next?
Speaker #1
Well, we can't forget about real estate. A popular ETF for that is the Real Estate Select Sector SPDR Fund, ticker symbol XLRE. This one mainly holds real estate investment trusts or REITs, which own and manage various types of properties.
Speaker #0
That's LRE for real estate. Makes sense. And I'm guessing we'll need an ETF for commodities too.
Speaker #1
Of course. You have a few options there. One is the Invesco DB Commodity Index Tracking Fund, ticker symbol DBC. This ETF tracks a broad basket of commodities, including energy, metals, and agricultural products.
Speaker #0
Wow, so many ETFs to choose from. It's amazing how easy it is to build a truly diversified portfolio these days. But I have a feeling the momentum calculations and rotation decisions might get a bit more complicated when you're dealing with so many different asset classes.
Speaker #1
That's where our trusty backtesting tools come in. Remember those? Yeah. They can help us analyze the historical performance of these various asset classes and see which ones have tended to exhibit the strongest momentum.
Speaker #0
Right. We can use backtesting to figure out not only which asset classes to include, but also how to allocate our portfolio and how often to rebalance.
Speaker #1
Exactly. You can experiment with different momentum lookback periods, different portfolio weights and different rebalancing frequencies. The software will simulate how those decisions would have impacted your returns over time.
Speaker #0
So we can test our ideas before we risk any real money. That's a huge advantage. Yeah. But I imagine backtesting can get pretty complicated, especially when you're dealing with a global portfolio like this. Any tips for making the process more manageable?
Speaker #1
One key tip is to start simple. Don't try to overcomplicate things right from the get-go. Begin by testing the basic Ivy portfolio allocation with a 12-month momentum look-back and monthly rebalancing. See how that performs over various historical periods.
Speaker #0
Okay, start with the basics and then gradually refine from there. What other tips would you recommend?
Speaker #1
Another important tip is to pay attention to transaction costs.
Speaker #0
Right.
Speaker #1
Remember, every time you buy or sell an ETF, you'll incur brokerage commissions and possibly even bid-ask spreads. These costs can eat into your returns, especially if you're rebalancing frequently.
Speaker #0
That's a good point. So we need to strike a balance between staying nimble and keeping costs in check. Any other advice for our aspiring global momentum traders?
Speaker #1
One final tip I'd offer is to be patient. These momentum strategies are not about getting rich quick. They're about building a robust, well-tested process and letting it play out over time. There will be periods of underperformance, but if you stick with the plan, the odds are in your favor.
Speaker #0
So the key takeaways are to start simple, be mindful of costs, and be patient. Sounds like good advice for any investor, really.
Speaker #1
Absolutely. These are fundamental principles that can guide you through the ups and downs of the market. And remember, there's always more to learn. The world of algorithmic trading is con- constantly evolving with new strategies and technologies emerging all the time. So stay curious, keep experimenting, and never stop seeking knowledge.
Speaker #0
Well said. This has been a fantastic deep dive into sector momentum and global asset class rotation. We've covered a lot of ground, from the basic concepts to advanced strategies, from specific ETFs to sophisticated backtesting techniques.
Speaker #1
We've given our listeners a solid foundation to start exploring this exciting area of algorithmic trading. Who knows? Maybe one of our listeners will discover the next big momentum strategy.
Speaker #0
That would be fantastic. Well, that's all the time we have for today's deep dive. We hope you found it informative and inspiring.
Speaker #1
And as always, we encourage you to do your own research, understand the risks involved, and adapt these concepts to your own individual needs and goals.
Speaker #0
Thank you for tuning in to Papers with Backtest podcast. We hope today's episode gave you useful insights. Join us next time as we break down more research. And for more papers and backtest, find us at https.paperswithbacktest.com. Happy trading!

Chapters

Introduction to Sector Momentum Trading

0sec

Understanding Momentum and Rotational Trading

39sec

Faber's Methodology and Trading Rules

1min

Performance Results and Market Comparison

2min

Risk Management Techniques

4min

Diversifying Beyond U.S. Stocks

5min

Combining Hedging and Diversification

6min

Practical Considerations for Implementation

7min

Expanding to Global Asset Class Rotation

10min

Advanced Strategies and Final Thoughts

19min