Monday, October 10, 2011

Emerging Market Rotation Strategy

Along with taking a deeper look at macro trends / releases to try to figure out this whole economy thing (in these all-too-interesting times), I spend quite a bit of my time creating (long-term oriented) trading models. The goal? To better allocate my investments by taking away some of my emotion.

The following model I will walk through is a simple model (available for download here) based on my friend Meb Faber's (of World Beta blog and Cambria Investment Management) Timing Model.

What is it...

It is an Emerging Market "EM" timing model that allocates between two EM sectors... fixed income and equities. As a way of background, since 1999 (I could only pull data for both indices as of December 1998 - due to the methodology below, the start of the model is 10 months later), both EM fixed income and equities have had very similar returns, but have had VERY different ways of getting there (see chart below). At a high level, EM equity tends to outperform when both are trending higher, but EM fixed income outperforms when EM beta struggles.

With that in mind... what is the model? On an end-of-month basis:
  • If EM Equity Total Return index > 10-Month moving average, allocate to EM Equities
  • If EM Equity Total Return index < 10-Month moving average, allocate to EM Fixed Income

The result? Over this time frame, the rotation strategy has significantly outperformed both EM fixed income and equities with volatility and drawdown levels right between the two (note that a 50/50 blend had returns of around 10.7% with slightly less volatility than the rotation strategy).

If anyone can pull data for EM indices going back further in time, please send my way as I'd like to see how this performs over the longer term.

Source: MSCI, JP Morgan, World Beta
Model: Download here