- This strategy exploits the anomaly that Cyclical Sectors and Small Caps perform best from November to April, and Defensive Sectors do better from May to October during most years.
- In this analysis only one ETF is periodically selected by a simple ranking system from the cyclical and defensive groups, respectively, and held for six months.
- Out of the 37 six-month periods, 36 periods showed gains ranging from 0.1% to 28.1%, while only one six-month period produced a loss of -9.3%.
- For the approximately 18.5 year period from end of Oct-1999 to May-2018 the backtest showed an annualized return of 19.8% with a maximum drawdown of -30%.
- For an “inverted” switching strategy, when cyclicals ETFs are used for the May-October period and defensive ETFs during November-April period, the annualized return was 3.2% and maximum drawdown was -60%.
The Case for Seasonal Switching
In this May-2013 article, What To Sell, If Selling In May, Doug Ramsey shows that since 1926 most of the excess return of Small Caps was earned during the seasonally strong months of November through April, and that one could have sat in cash each May through October and beaten “Small Cap Buy and Hold” on a total return basis.
The article also demonstrates that since the inception of the S&P 500 sector data in late 1989 it would have been beneficial to own cyclicals (Discretionary, Industrials and Materials) during the seasonally strong market months of November through April, and then swap into defensives (Staples, Health Care and Utilities) for the May to October period.
The iM Seasonal Switching Model
|ETF||The cyclical ETFs used for the analysis are:|
|XLY||Consumer Discretionary SPDR ETF|
|XLI||Industrials SPDR ETF|
|XLB||Materials SPDR ETF|
|XLK||Technology SPDR ETF
rev.11/22/20: XLV replaces XLK
|VBR||Vanguard Small-Cap Value ETF|
|ETF||The defensive ETFs used are:|
|XLP||Consumer Staples SPDR ETF|
|XLV||Health Care SPDR ETF
rev.11/22/20: XLK replaces XLV
|XLU||Utilities SPDR ETF|
|VIG||Vanguard Dividend Appreciation ETF|
|IEI||iShares 3-7 Year Treasury Bond ETF|
The model was back-tested on the on-line simulation platform Portfolio123, which provides historical economic and financial data as well as extended price data for ETFs before their start dates. Only one ETF is periodically selected from each group of five ETFs by a simple ranking system and held for six month. There is no market timing or stop-loss rule in the model.
A simple ranking system is used which is based on the price changes over a short period. The notion is that ETFs which have experienced a decline over a short period will bounce back, reverting and doing better than ETFs which have not declined in this way.
In the Appendix is a listing of all the 37 completed transactions. The only loss over any of the 37 six months investment period was -9.3% for the period 10/22/2007 to 4/28/2008 during the Great Recession which officially lasted from December 2007 to June 2009.
The red graph in Figure-1 shows the performance of the model with dividends and with trading costs and slippage accounted for. The blue graph represents the buy&hold performance of SPY (the ETF tracking the S&P 500 index). The model greatly out-performed SPY which only produced an annualized return of 6.0% with a maximum drawdown of -55%. Over the full period from end of Oct-1999 to May-2018 the total return of the model is 14-times that of SPY.
Performance by Calendar Year
The backtest shows only positive calendar year returns and produced positive returns for each calendar year, and excess returns over SPY in 13 out of 19 years.
What happens if the strategy is inverted?
Figure-2 shows the performance when an “inverted” seasonal switching strategy is adopted – when cyclicals ETFs are used for the May to October period and defensive ETFs during the seasonally strong market months of November through April. Again only one ETF is selected and held for six months.
The annualized return collapses to 3.2% with a maximum drawdown of -60%. Over the full period from end of Oct-1999 to May-2018 the total return of the inverted strategy model is only about 40% of SPY.
What happens if more than one ETF is periodically selected?
The performance diminishes if the model holds more than one ETF. The table below lists annualized returns and percentage of winning trades for the model holding one to five positions. For all cases performance is significantly better than for buy&hold of SPY which only produced an annualized return of 6.0% over the corresponding time period.
|Number of Positions||Annualized Return||Percentage Winners|
Backtesting with historic data shows that investment returns can be vastly improved by employing a seasonal ETF switching strategy. Minimum trading effort is required as one would only switch between ETFs every six months, namely on the first trading day of the last week in April and October of each year.
The performance of this model and ETF selection will be reported bi-annually.
Transactions (Return is without dividends)