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


  1. I have a question regarding alphaclone. I've emailed customer service, but haven't heard anything back.

    It's sort of a broad question, so maybe you can answer it here. Regarding re-balancing... is the follower of a 'clone' portfolio supposed to sell or buy the stocks they already own at the end of each quarter to bring the allocations in line?

    For example, say one has 10 stocks in their portfolio. And at the end of the quarter one of the stocks has gained a tiny bit and is now representing 11% of the portfolio rather than 10%. Am I supposed to initiate a sell order for just the right amount of shares to bring the stock back to 10% of the portfolio?

    I ask because it seems that you would inevitably be making 20 trades to bring everything perfectly in line each quarter. A lot of trades...

    And maybe on this same topic, I'm also confused why under the RECENT TRADES section, some of my clone portfolios show selling AND buying the same stock at the same price, during the same re-balancing date. Any help would be much appreciated. Thanks

  2. Chancee- I am not affiliated in any way with AlphaClone (though I find their service and the results interesting).

  3. great post- thanks for sharing. what are the etf's that can be used for implementation?

  4. EEM tracks the MSCI EM index and EMB tracks the JPM EMBI index

  5. would add another simple rule. if BOTH indices are below their respective 10-month moving averages then simple stay CASH.

  6. GREAT IDEA AND STRATEGY !! Just thinkin' out loud though... what are the chances of anyone sitting through a 42% drawdown? In a $100K portfolio allocation, that is $42,000 dollars. Seems to me just talking to people that they start to freak out after their investments go down 10-15%. (just an observation). Even the talking heads in the media start with the sky is falling stuff at about 15-20%???...

  7. Riccardo- this doesn't work (tried it). You don't miss the initial drawdown, then you miss the upturn. Remember - EM markets move fast!

    Anon- the drawdown is tough, but much better than EM equities and right in line with the S&P 500. Remember- even if this proves to be a winning strategy, it shouldn't be a stand alone investment, but rather a sleeve of a portfolio (i.e. any EM investment needs to be diversified).

  8. What is an easy way to figure out the 10-Month moving average of the EM Equity Total Return index ?

  9. Average each end of month value. You can use ETF EEM as a proxy.

  10. Jake,

    I cover EM equities for a private wealth management firm and have been using a similar iteration of this signal for a couple years, great post!

    In response to the comment about a -42% drawdown...yeah but you turned $100 into $800-900, who cares if it had a draw down :)

  11. I pulled up a chart comparing EEM with EMB. They seemed to pretty correlated albeit at much different percentages. Looks like I'd be better off going to cash when EEM dips below it"s 10 month sma.
    Am I missing something?

  12. Larry- try that and see how the results look. If you don't feel like putting forth the effort, the answer is not as good in return terms, but lower volatility. Thus, the answer to what you are missing is what is your risk tolerance.