Strategy: Buy Top-Performing ETFs (US Markets)

Click here for the version for Canadian markets

Overview

• This tactical asset allocation strategy switches between the best-performing assets among a basket of diversified passive index ETFs.
• The goal is to outperform the market over the medium and long term by capturing most of the upside of the growth assets while significantly reducing drawdowns by switching to defensive assets in bear markets.
• This type of strategy has been extensively studied and written about (see recommended reading). Still, it continues to be effective because it relies on market momentum (trend following), a persistent market feature.
• Compared to buy & hold strategies, this strategy requires additional effort. It is tax-inefficient (if held outside a tax-sheltered account) but has much better returns and significantly smaller drawdowns in exchange.

General Rules

• Select a diversified basket of ETFs (ideally with low correlation).
• At month’s end, rank the performance of each ETF (including reinvested distributions) using the average of 3/6/12-month price change.
• Buy (or continue holding) an equal dollar amount of the top-ranked ETFs (best performance).
• Rebalance monthly (if large enough to matter compared to the associated transaction costs).

Variations

• Option #1: Global Balanced
• Option #2: US Sectors
• Option #3: Country Indexes
• Option #4: Meta-Strategy

Option #1: Global Balanced

Assets

The average correlation between the daily price movements of these ETFs is low at 0.30 (0.00–0.44).

Performance (Jan 2003–Dec 2023)

Option #2: US Sectors

Assets

The average correlation between the daily price movements of these ETFs is low at 0.34 (–0.16–0.50).

Performance (Jan 2003–Dec 2023)

Option #3: Country Indexes

The average correlation between the daily price movements of these ETFs is low at 0.41 (–0.18–0.53).

Performance (Jan 2003–Dec 2023)

Option #4: Meta-Strategy

This strategy uses an equal weighting of the three previous strategies.

Performance (Jan 2003–Dec 2023)

Returns by Year

Portfolio Considerations

Taxes — Very tax-inefficient. It is most suitable for tax-sheltered accounts unless you have limited taxable income, as it often generates capital gains, primarily as short-term gains.

Contributions — Are supported at any time. Since this strategy generates new target positions each month and will switch positions often throughout the year, it can absorb contributions quickly with minimal or no additional transactions.

Withdrawals — There will be many opportunities to withdraw cash without triggering additional capital gains throughout the year. Also, existing positions can be trimmed if necessary. Since drawdowns are much smaller than with buy & hold, there is significantly less timing risk for unplanned withdrawals.

Minimum Account Size

• $5,000 — when using a zero-commission broker (less if they support fractional shares).
• $50,000 — when transaction costs are $9.99 to get total annual transaction costs under 0.5%.

Maximum Account Size — this is unlikely to be a problem if you’re investing your own money, unlike the Canadian version of this strategy. The Country Portfolio has a few lower-volume assets that may be limiting to accounts worth more than $5 million, but the other two portfolios can easily handle tens of millions of dollars.

Diversification

• Option #1: Global Balanced — diversified by asset classes and geography.
• Option #2: US Sectors — mainly diversified by market sector but concentrated in US assets with minimal international exposure.
• Option #3: Country Indexes — mainly diversified by country without much exposure to specific sectors.

Note: there will be times when all the positions held by these strategies could be concentrated in higher volatility assets, increasing the chances of more significant drawdowns during market shocks.

Effort — Requires calculating the monthly ETF performance rankings and potentially executing time-sensitive transactions. You can do these calculations yourself or subscribe to my monthly newsletter.

Timeframe — Ideally, it should be at least two years, the shortest rolling period with positive returns 95% of the time.

FAQ

Which strategy is the best choice for me?

It depends on what other types of assets you hold in your portfolio and what your goals are:

• Option #1: Global Balanced — This strategy is the best choice for most people. It’s broadly diversified geographically and by asset class and has been studied extensively by experts. It should keep pace with or outperform buy & hold with much smaller drawdowns.
• Option #2: US Sectors — This strategy is less globally diversified but more optimized for taking advantage of specific outperforming sectors. It can be an excellent complement to Option #1.
• Option #3: Country Indexes — This strategy is the most geographically diversified but has less sector-specific exposure. It has higher returns and larger drawdowns than the other two strategies, but it has underperformed during the 2010s, as US markets have outperformed most of the world. How long this can continue is an open question, but at some point US returns will revert to their historical average.
• Option #4: Meta-Strategy — For more extensive portfolios (e.g. 300K+), allocating a portion of your portfolio to each strategy increases diversification, decreases drawdowns, and increases the % of positive years.

Why use the average of 3/6/12-month returns?

The goal is to calculate the direction of each asset’s trend (momentum). Broad-based ETFs move slowly enough that looking at their performance over the past year is a good gauge of overall direction. But if we only compared today’s price to a single historical price (e.g. 12 months ago), we wouldn’t know the shape of the price movement—is it trending up recently, or was all the price appreciation nine months ago? We want a chart that is trending up and to the right. Using the average 3/6/12-month performance is a simple way (but hardly the only way) to give us a sense of the overall direction.

Why does it work?

Ranking the assets based on their performance gives us a statistical edge in predicting the price performance for the next month—the strongest assets tend to outperform the weakest ones. Notice that the average monthly return and % positive months correlate roughly to rank.

Next Month’s Return vs. Performance Rank for Global Balanced Portfolio

Why use the top 3 (rather than the top 1 or 5)?

The top-ranked asset often has the highest average monthly return but a lower worst-case return and lower % positive than other top-ranked assets. As such, investing only in the top-ranked asset will typically have higher returns and disproportionately higher drawdowns. Buying just the top-ranked asset can be a reasonable place to start if you have a smaller account and a longer investment time horizon (e.g. more than five years).

The top 3 give us a better balance between returns and drawdowns.

Using the top 5 usually doesn’t help reduce drawdowns and typically lowers returns.

Why these specific ETFs?

In general, my selection criteria were:

• Longest history available (ideally 20+ years)
• Most daily volume
• Not highly correlated to another asset

The reasoning for each portfolio were:

• Option #1: Global Balanced — This portfolio is modelled closely after Meb Faber’s GTAA 13 Agg 3 and Brian Livingston’s Papa Bear Portfolio. It starts with four US equity indexes (IWF, IWD, IWO, IWN) representing growth versus value and large-cap versus small-cap stocks. It complements those with European and Asia stocks (EFA) and emerging markets stocks (EEM). And finally, adds commodities, real estate, bonds, and treasuries as defensive assets.
• Option #2: US Sectors — This portfolio uses all the most liquid US sector-specific equity funds. It complements those with real estate, bonds, treasuries, and gold as defensive assets.
• Option #3: Country Indexes — This portfolio uses all the most liquid country-specific equity funds. They are filtered to minimize correlation, so lower volume, highly correlated countries are discarded. They are not selected for past performance because we don’t know which countries will outperform in the future. For example, historical returns would have been better if the Japanese and Indian indexes had not been included.

Don’t many of these funds have higher management fees?

Yes, specialized sector funds tend to have higher MERs than funds tracking the overall market (0.6% vs. <0.1%). But that is the cost of getting more concentrated funds. I would not want to buy & hold these ETFs for precisely that reason, but they are well suited for this strategy.

I mainly chose iShares & SPDR funds because they have been trading the longest and thus give us more data to validate the strategies. In the future, I will review if there are newer ETFs that have higher daily trading volume or lower management fees that may be worth substituting.

How important is the timing of executing trades?

This is an important question since the historical performance shown above is idealized in that it’s based on calculating the rankings using the closing price (i.e. after the markets close) but assumes that we executed trades as the markets closed. So, what’s the best way to implement this system?

The first (and easiest) choice is, in the evening after the markets close, enter a limit order at the close price (maybe with a little buffer) that will remain open for a few days and expect that it will get filled (which it usually will). On the rare occasion when it doesn’t, hold your nose, accept the slippage, and buy at the current market price.

The second choice is to execute the trades at the market open the next day (either in real-time or with market orders). If prices move overnight, usually everything will move together, so, for example, you might receive a worse fill on your sell but a better fill on your buy.

The third choice is to calculate the target positions just before the market closes (e.g. 15 minutes), execute a market-on-close (if your broker supports them), and assume that the position signals won’t change in the last few minutes of the market session (which they rarely will). This method will get us closest to the idealized performance but has the disadvantage of being very time-sensitive and not knowing precisely what price your orders will be filled at.

Overall, it is advantageous to implement the new positions at month-end because there is a natural performance benefit to the end-of-month price specifically. But, the price traded will not significantly affect your overall returns. This strategy vastly outperforms buy & hold. Therefore, we won’t be undone by a bit of slippage. Pick the execution method that works for you, keep it simple, and don’t stress over it. This strategy only takes a few minutes a month to implement and can be managed entirely outside open market hours.

For reference, here is a breakdown of the historical performance impact of different trade times for the Global Balanced Portfolio.

Why start in January 2003, and how do you handle assets that began trading later?

I wanted to start the analysis as early as possible, so I chose a threshold of six available assets as the minimum (twice as many as held each month), including some defensive assets. The strategy will struggle in bear markets, like buy & hold, unless defensive assets are available. The remaining assets became available to the system once 12 months of history were available (to calculate the 3/6/12-month performance).

Having all assets available rather than six improves diversification and performance and reduces drawdowns. But even using only the original six assets throughout the test, it still handily outperforms buy & hold.

How are the number of trades calculated?

The average number of trades per year (18.2–23.2) counts two trades each time an asset drops out of the top 3 and is replaced by another (i.e. one buy and one sell). It does not count trades to rebalance since I don’t know the size of your portfolio and how often it will be cost-effective for you to rebalance. In ~30% of months, the monthly performance difference between the best and worst performing asset held is more than 10%, so there will be at least a few times per year when the positions become obviously unbalanced.

Recommended Reading

• The Ivy Portfolio: How to Invest Like the Top Endowments and Avoid Bear Markets (Meb Faber, 2011)
• Global Asset Allocation: A Survey of the World’s Top Asset Allocation Strategies (Meb Faber, 2015)
• Muscular Portfolios: The Investing Revolution for Superior Returns with Lower Risk (Brian Livingston, 2018)
• Dual Momentum Investing: An Innovative Strategy for Higher Returns with Lower Risk (Gary Antonacci, 2014)

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