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Our blog entry of 6/12/08 summarizes a simple momentum trading strategy that trades each month into the one of nine sector exchange-traded funds (ETF) with the highest total return over the prior six months. The strategy outperforms the broad stock market since introduction of these ETFs. A reader comments and asks:
"Many value investors say they scan for 'new lows.' Would a similar methodology apply to ETFs? How do the bottom performers (lowest prior six-month return) work for this test? My guess is that the ranking period would have to be longer than six months (say, one year or three years) and that the holding period would have to be longer than one month to generate positive returns."
To investigate sector ETF reversion, we test two trading strategies on the following nine sector ETFs defined by the Select Sector Standard & Poor's Depository Receipts (SPDR), all of which have trading data back to December 1998:
Materials Select Sector SPDR (XLB)
Energy Select Sector SPDR (XLE)
Financial Select Sector SPDR (XLF)
Industrial Select Sector SPDR (XLI)
Technology Select Sector SPDR (XLK)
Consumer Staples Select Sector SPDR (XLP)
Utilities Select Sector SPDR (XLU)
Health Care Select Sector SPDR (XLV)
Consumer Discretionary Select SPDR (XLY)
The first (6-1) reversion trading strategy starts with $10,000 and each month puts all funds into the one of the above ETFs that has the lowest total return over the prior six months. The second (12-6) reversion trading strategy also starts with $10,000 and every six months puts all funds into the one ETF with the lowest total return over the prior 12 months. Using monthly adjusted closing prices for these ETFs and for the S&P 500 index mimicking SPY (to represent the overall stock market) over the period 1/99-5/08 (113 months), we find that:
We make the following assumptions in testing these trading strategies:
Note that the available sample size (less than ten years) is a problem for testing slow reversion. A ranking period of one year means fewer than ten independent rankings, so confidence in findings is very low.
The following chart compares the cumulative value of a $10,000 initial investment in the 6-1 reversion trading strategy at the end of June 1999 (blue line) to that of a $10,000 buy-and-hold investment in SPY (green line). The chart also includes for reference the comparable result for the 6-1 momentum trading strategy from our blog entry of 6/12/08 (red line).
The 6-1 reversion trading strategy slightly underperforms buying and holding SPY. The average monthly return for the 6-1 reversion strategy is 0.2%, compared to 0.2% also for SPY. The standard deviation of monthly returns for the momentum strategy is a very volatile 7.4%, compared to 4.0% for SPY. It appears that the reversion trading strategy may modestly underperform (outperform) a declining (advancing) market. Overall, reversion does not work for the 6-1 parameters.
What sectors drive the performance of the 6-1 reversion trading strategy?
The next chart shows the distribution of ETFs selected by the 6-1 reversion trading strategy over the entire test period. The technology sector comprises 30 of the 107 monthly selections (28%). The strategy participates very little in the energy sector (XLE) boom.
Do longer ranking and holding periods improve the results of reversion trading?
The final chart compares the cumulative values of $10,000 initial investments at the end of December 1999 in the sector ETF 12-6 and 6-1 reversion trading strategies. The average monthly return for the 12-6 reversion trading strategy is 0.4% with standard deviation 7.6%. While the longer ranking and holding periods result in modestly improved returns, volatility is still high and the outcome remains unattractive.
In summary, simple reversion strategies applied to sector ETFs over the past decade generate unattractive returns with high volatility.
Again, the sample is very small in term of number of independent six-month and one-year momentum calculation intervals. There is not enough data to consider testing a three-year ranking period.
For related research, see Blog Synthesis: Momentum Investing/Trading.
