ETF Country Plus Strategy Insights: Designing a Strategy (Part 4)

Mish Schneider | May 18, 2014

This week we made one position change in the ETF Country model.  On Wednesday morning we sold out of EWP on the open and entered into an equal sized position in IFN (India).   Our current three positions are EGPT, TMF, and IFN.  To open next week, we will remain in those three ETFs.

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The MSCI World Index closed the week up +0.46%.  The ETF Country Plus model ended the week up +4.74% thanks to great weeks from all three of our current holdings.  The ETF Country Plus Strategy is up % year-to-date compared to its benchmark, the MSCI World Index, which is now up +2.46% year-to-date.

This Week’s Strategy Lesson: Designing a Strategy (Part 4)

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We are now several weeks into a series of articles on the process of designing robust strategies that can beat the market.  We have talked about starting with a central concept and then building a universe of trading instruments around it that will best take advantage of the primary strengths of your trading concept.

This week we are going to talk about the pros and cons of money management systems and how we decided on the one we implemented in our ETF models.

Money Management:

A lot of trading ideas naturally feel more complete then they actually are.  Take for instance a moving-average crossover system.  Here you might buy a stock when the fast moving average crosses above the slow moving average.

Sounds like a plan, right?  Well, you have yet to define your position sizing (how much capital to allocate to this trade relative to your whole account), profit target(s), initial and trailing stops, and still more questions like how many of these signals you might trade in a day and how many losses in a row it would take for you to decided your strategy might need some tweaking.  Let’s cover some of these questions within the context of our ETF strategy.

When we set out to design the ETF strategies we were specifically trying to come up with a model that would have a longer term approach, giving us consistent market exposure.  We knew we wanted to use the top of our trend strength rankings for our positions, but how many positions that would be was far from answered.

We had to strike a balance between two competing but important concepts.  On the one hand, we wanted to make the strong concentrated bets on the top sectors.  But did that mean we should only be in the highest ranked ETF?  At the same time, we understood the importance of diversification from a risk management perspective and from a model perspective, we knew that there usually isn’t only one hot sector in the economy.

We kept these two concerns in mind and after testing our many ideas, we decided that three equal-weighted positions in the top three ranked ETFs drew the right balance.  This gives us equal exposure to a variety of sectors while still keeping us concentrated enough to avoid diluting our gains or being in underperforming sectors.

Stops and Targets

There is probably no question we get asked more than why we decided not to use stops and targets.  The answer to this question is multifaceted.  First, we won’t rule out future versions of the model using stops or targets.  It is very possible that a system could be designed that would improve our model and we are constantly trying out new ideas and working with the data to look for improvements.  But it should be said, the model works very well without them.

And while we don’t have traditional stops, the rotational aspects of the model essentially provide it with “synthetic” stops.  If one of the lead ETFs starts to stall out, we would sell out of it when a new ETF leader emerges, effectively putting in a stop relative to the other ETFs.

Also, we know that if the trend strength goes negative, we will go into cash.  However, we can’t necessarily know ahead of time when this might occur as the trend strength indicator is “adaptive” to market conditions within our universe of ETFs.

Finally, the inclusion of short exposure ETFs means that when the market starts to pull back, we can switch into those ETFs faster.  The performance of treasuries (TMF in our model) recently, typically seen as a counter-cyclical instrument, is a good example of this.  While the broader markets have been mostly sideways for months, treasuries have been steadily gaining ground and are near the top of both of the ETF model’s ranking despite only being days away from new highs in the SPYs.

Compounding vs. Profit Taking

The last money management component I will cover today is the question of how long to stick with a trade or how often you should take profits along the way.  Every system will be different on this topic.

MarketGauge has spent a lot of time developing sophisticated profit targets and strategies for swing and day trading systems.  And in general, it is a great idea to take profits along the way.  But there is a give and take on this issue as well.

Every time you take profits, you are reducing your ability to make money from a continuation of the trend, but you are also ensuring that you make money on the trade and that your risk/reward stays in line with the probabilities.

We have a unique problem in the ETF strategies in that we never know ahead of time how long a trend will persist.  We might be in a trade a couple days or a couple hundred days (our current shortest open position is 2 days and longest is 226 days!).  If we aggressively take profits early in a position, we might end up in a scenario where we are seriously underexposed to what might end up being the best trade of year.

For the backtest and model portfolio, we continue to maintain full market exposure, giving us full access to the power of compounding, but the answer to how you might manage our strategies is still an open book.  Depending on your own risk tolerances, a strategy of taking profits every 20% might suit your own style better.

We modeled a simple money management technique where anytime you are up 20% in the ETF strategy, you take that 20% off the table and resume with your original capital allocation.  Using this technique throughout the backetst period, you would be up 215% all while constantly pulling money out of the market, reducing volatility, and keeping a constant risk exposure.  You give up some upside, but for many traders, a system like this would help them sleep better at night.

Ultimately, money management proves to be one of the most important topics in strategy creation.  A well designed system can improve even the weakest models whereas a poorly designed system can take a high probability market timing signal and turn it into a low probability money making system.  Care and thought should be applied liberally in this area.

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The Current Condition of the Model

For the country model, we are now in EGPT, IFN, and TMF.  India had an impressive move this week off of election results that were seen to be very pro-growth/pro-business.  The treasuries (TMF) also have been outperforming and were up 6% this week.

Here is a summary of the weekly performance of all the ETFs that the strategy monitors:

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Best wishes for your trading,

James Kimball
Trader & Analyst
MarketGauge