MARKET TIMING
The Style Index
Index Rotation With Exchange - Traded Funds
by David Vomund
If you watch CNBC, you'll notice that growth managers always say growth will outperform, value managers always say value will outperform, and small-cap managers always say small-cap stocks will outperform. Every analyst has his unique approach, and he believes his style is best. Unfortunately, market environments change. That means there are times when growth outperforms value and vice versa, and times when large-caps outperform small-caps and vice versa.The stories you tell reflect your worldview -- and they can help you succeed. THE STYLE INDEX ROTATION STRATEGY
Instead of being locked into one trading style, it is best to employ a strategy that allows the user to rotate to the best-performing market segment. That's what our style index strategy is all about.
The style index strategy trades securities that track various market indexes. These "style" indexes include large-cap growth, large-cap value, small-cap growth, small-cap value, and so forth. While mutual fund families like the ProFunds have funds that track these indexes, the best vehicle for trading style indexes is exchange-traded funds (ETFs), the fastest-growing financial product in the US.
First launched in the early 1990s, ETFs are securities that combine elements of index funds, but do so with a twist. Like index funds, ETFs are pools of securities that track specific market indexes at a very low cost. Like stocks, ETFs are traded on major US exchanges and can be bought and sold anytime during normal trading hours.
Trading style indexes allows investors to gain well-diversified exposure to a specific area of the market. Since an ETF holds a basket of stocks, one bad performer should have only a minimal effect on the price of the ETF. For more information on ETFs, visit www.amex.com.
Since price history on ETFs is limited, we cannot run a comprehensive backtest and develop a model that covers both bull and bear markets. Most ETFs began trading in 2000. Therefore, a backtest of a trading system cannot be run using ETF trades but must instead be run on the benchmark indexes that the ETFs track.
Here's an example. Before the Nasdaq 100 ETF (QQQ) was traded, this backtest purchased the Nasdaq 100 index. Before the Dow Diamond was traded, the backtest bought the Dow Jones Industrial Average (DJIA). Before the iShares Small-Cap Russell 2000 was traded, the backtest bought the Russell 2000 index. A list of the ETFs used in the backtest along with their benchmark indexes can be found in Figure 1.
Looking at Figure 1, there is a growth and a value choice for both large-cap and small-cap stocks. Instead of adding a growth and value choice for mid-cap stocks, we only follow one mid-cap index. Traders can add more ETF choices to this list.
I used AIQ's TradingExpert to run the strategy. This software has a prebuilt report called the relative strength--short term report. The report's calculation is simple. It looks at the last 120 days of data (approximately six months) and breaks them into quarters. A percentage change is calculated on each quarter and then the percentage changes are averaged, with twice the weight placed on the most recent quarter's data.
...Continued in the January issue of Technical Analysis of STOCKS & COMMODITIES
Excerpted from an article originally published in the January 2005 issue of Technical Analysis of STOCKS & COMMODITIES magazine. All rights reserved. © Copyright 2004, Technical Analysis, Inc.
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