There were no position changes in the Country models this week. The Basic model had a decent selloff with TMF falling hard from its all-time high close last Friday. The Stops & Targets model actually put in a positive week thanks largely to it not holding TMF. China closed the week positive but it just made it back to our entry price and the TSI rank has fallen to fourth place while India closed the weak down half a percent.
The broader market had a strong week, moving off the trading range lows, but the rally petered out on Friday and closed towards the middle of this recent trading range.
This Week’s Strategy Lesson: ETF Model Drawdowns (Part 1)
The The ETF models in all their various forms offer a spectrum of investment opportunities. The Sector Fund has some of the best returns, though at the cost of added volatility and the potential for larger drawdowns. The country fund, while it can put in some excellent returns, tends to be more conservative in both performance and as measured by several key risk metrics. The ETF Complete attempts to balance out these extremes, taking advantage of the potential for higher performance while mitigating the risks with a significantly higher level of diversification.
Understanding the trading characteristics of each model can help us better make all the ancillary decisions around trading. Decisions like determining how much capital to allocate to a system, or how aggressively to get started, or what you can expect from trading the systems.
Drawdowns are one of the most important things to understand about a model. It should be noted that the drawdowns we are going to be looking at are those that have occurred in the historical backtest of these models going back over eight years now.
The history of the model can tell us a lot about the types of drawdowns that we can expect, but it does not preclude the possibility that we could have worse drawdowns or drawdowns of a different character in the future.
In an upcoming article, we will walk through a Monte Carlo simulation that attempts to “stress test” the ETF models through generating thousands of alternative trading histories. From these alternative histories, we can infer what might be the best and worst case scenarios and the probabilities of such things happening.
What is a Drawdown?
A drawdown occurs when your equity goes from putting in new highs to moving off of those highs. Ultimately, we cannot know what the maximum of any drawdown is until the equity proceeds to put in a brand new high. It can be very helpful to look at an illustration.
In the chart above, the equity puts in a new “peak” high at $1,200 in July. Over the next couple of months the equity sells off down to about $1,050. This happens to be the lowest it sells off to before it puts in a new high a year later, but we cannot declare that low as the maximum “peak-to-trough” drawdown until we see it put in that new high. The time to recovery is simply the length of time between when the equity puts in a peak high and then finally puts in a new high.
The frequency and severity of drawdowns can play a big role in how hard or easy it is to stick with a trading system. Frequent, deep drawdowns can test your resolve to stick with a longer-run winning system. They also increase the risk that the model could have a down period the period that you end up needing to use the money from trading it.
That is one reason why financial planners tend to recommend investors move into a greater share of bonds as they approach retirement. The bond market offer less return than the stock market but typically with much less volatility (you don’t want to take the risk that the market has a down year the year that you start retirement or that you won’t have time to leave the money in the market to recover because you need it for living expenses).
Largest Historical Drawdowns
The historical backtest of our ETF models goes back to the beginning of 2007. This date was chosen for a couple key reasons. We wanted to go back to at least 2007 so that the backtest would include a variety of market conditions including the worst stock market drawdown in recent history. However, the world of ETF investing is rather new and constantly changing, so we would run into difficulties creating and testing our current ranked list of ETFs if we went back further than 2007.
While the worst historical drawdown for each model can seem large, it should be properly weighed against both the returns of each model and the period that it took place in. All of the models both outperformed their benchmarks (SPY and MSCI All World Index) and had significantly smaller drawdowns. The data below is on a week-ending basis.
The 56% drawdown in the SPY took almost 2000 days to recover. One reason why the 2nd and 3rd largest drawdowns in the SPY were small was because the largest drawdown consumed a large portion of the backtest period.
The ETF Complete Portfolio had the lowest drawdowns of all the models at a very modest 13%. This is achieved by synergistically diversifying into the three models (Sector, Country, and Global Macro). The trade-off is lower overall performance than the Sector Basic model (the largest drawdown of the ETF models).
Ultimately it is about these trade-offs. What we would prefer is stellar performance with no drawdowns, but that is probably not possible to achieve. What we have is few different models that fit on different points of the risk/return curve (drawdown being only one factor in measuring the riskiness of a model).
Next week we will dive deeper into the data and look at how the frequency and severity of the drawdowns relates to how much capital you should be allocating. After that, we will look at what we can learn about the model based on running several Monte Carlo simulations.
The Current Condition of the Model
For the country model, we are in FXI, IFN, and TMF. FXI fell out of the top three ranks but it will take another decent move down in FXI or up in SSO before a position change will be triggered.
Stay tuned to daily updates for any position changes.
Here is a summary of the weekly performance of all the ETFs that the strategy monitors.
Best wishes for your trading,
James Kimball
Trader & Analyst
MarketGauge
