Paired Switching Portfolio Allocation, Part 2

Yesterday I detailed a paired switching portfolio allocation strategy using SPY (SPDR S&P 500) and TLT (iShares Barclays 20 Year Treasury Fund) and offered back test results dating to 2003. Based on the feedback I received there is interest in the strategy so  I decided to test different pairs of ETFs using the same metrics as yesterday's tests.

The limitation of the tests are primarily the time frame - most ETFs have relatively short trading histories so it is difficult to draw strong conclusions on the historical merits of the strategy.  Nevertheless, the system shows some signs of promise as a simple paired strategy using non-correlated ETFs.  The most promising results of the pairs tested is a natural resource/long-term treasury pair.

Test 1 - EFA (iShares MSCI EAFE Index Fund) and TLT

First, we began with the 3 month relative strength results.  The ETF which had the highest 3 month relative strength among the two was purchased each month (monthly re-balance). For the sake of consistency, I used SPY as the benchmark for all tests:



Trades                            CAGR       Sharpe Ratio     SPY Correlation     Max Drawdown
   47              Backtest      17.40%         0.85                      0.08                -21.40%
Total Periods     SPY           6.10%          0.24                                            -55.20%
   107    
   
Total Days    
  2236    
   
Next, we perform the same test using 6 month relative strength ranking to determine the ETF position. The results are below for EFA and TLT:



Trades                                        CAGR       Sharpe Ratio     SPY Correlation     Max Drawdown
   27               Backtest       12.70%        0.61                     0.09               -26.00%
Total Periods      SPY            6.10%         0.24                                           -55.20%
   107    
Total Days    
  2236    
   
Test 2 - SPY and SH (ProShares Short S&P 500)

For this test, SH began trading in 2006 so the results are more limited.

The 3 month relative strength results:



Trades                                        CAGR     Sharpe Ratio     SPY Correlation     Max Drawdown
   25               Backtest        8.20%           0.3                   -0.5                 -24.60%
Total Periods     SPY             2.20%           0.06                                        -55.20%
   71    
Total Days    
  1480    
   
The 6 month relative strength results:



Trades                                     CAGR      Sharpe Ratio     SPY Correlation     Max Drawdown
   15               Backtest       5.80%      0.21                       -0.4                 -39.30%
Total Periods     SPY            2.20%      0.06                                             -55.20%
   71    
Total Days    
 1480    


Test 3 - SPY and SHY  (iShares Barclays 1-3 Year Treasury)

The 3 month relative strength results:



Trades                                       CAGR     Sharpe Ratio     SPY Correlation     Max Drawdown
49                  Backtest       9.00%          0.56                 0.47                 -12.60%
Total Periods     SPY            6.10%          0.24                                        -55.20%
107    
Total Days    
2236    
   

Next, the 6 month relative strength results for SPY and SHY:



Trades                                       CAGR     Sharpe Ratio     SPY Correlation     Max Drawdown
35                 Backtest        9.30%             0.54              0.53                 -17.30%
Total Periods     SPY            6.10%             0.24                                     -55.20%
107    
Total Days    
2236    
   
 
Test 4 - IGE (iShares S&P North American  Natural Resources ) and TLT

Perhaps the most intriguing results of the four tests is the pair of IGE and TLT.  First, the 3 month relative strength test results:



Trades                                    CAGR      Sharpe Ratio      SPY Correlation     Max Drawdown
 59               Backtest      19.00%         0.78                   0.14                  -21.40%
Total Periods     SPY          6.10%          0.24                                          -55.20%
107    
Total Days    
2236    
   
The 6 month relative strength results:



Trades                                   CAGR      Sharpe Ratio     SPY Correlation      Max Drawdown
35                Backtest      18.00%         0.73                 0.14                    -31.40%
Total Periods     SPY           6.10%          0.24                                           -55.20%
107    
Total Days    
2236