No. of Recommendations: 67
Executive Summary
This post details a series of backtests using a slightly modified Riding the Wave strategy -- i.e. trading monthly -- using baskets of poorly correlated investments including major developed markets, gold, currencies, bonds and commodities.

By using monthly data, a 30 year backtest is possible. In various baskets, reasonably attractive performance was seen over the past 5 years (CAGR in the mid 20s, GSD around 9, Sharpes over 0.4), but this does not hold for earlier time frames; the overall 30 year performance wasn't any better than buying the equity indices of the basket in equal weights.

---------------------------------------------------------------

Hi, folks. I'm a long-term lurker with an Excel addiction, and since I finally took the plunge into MI a year and a half ago (I started reading here back in '98 or '99), I've been wanting to help contribute something.

I've been interested in the Riding The Wave concept, so I thought I'd have my own look at it; kick the tires, so to speak, before I took it out for a spin. What I found surprised me.

Data
Since we're talking about using index funds, I thought I'd have a look at using various international stock indices as a proxy. Kenneth French's web site provides monthly historical index values for 15 major developed markets, about 97% by market cap. I extended S&P's historical S&P 500 index data back to 1976 with a historical series from Ohio State, and I found gold, T-bill and 10 year treasury bonds from a site I Googled called Wren Investments. I added in the CCI and CRB indices, as well as the CRB Currency index from CRB (the Commodity Research Board). Finally, using current national market cap values from S&P, I back-calculated synthetic indices grouping the developed markets into various chunks; Asia Pacific ex Japan, for instance (i.e. Hong Kong, Australia and Singapore). In the end, I wound up with a basket of 31 different investment types for consideration.

The reason I looked to these sources is simple: These data are all available going back to 1976, permitting a 30 year backtest of this general method.

One big caveat with all of this, of course -- the input data is only monthly, so the trading process of RtW is approximated; monthly instead of weekly or daily, and the lookbacks are similarly approximated; 2 and 11 months (roughly 42/231 instead of 50/235). The results I present are consistent when small adjustments are made -- to 3/11, or 2/12, for example. This fits with descriptions of a mound of toast around the 50/235 range. There's also no go-to-cash switch; I don't know anything about switches of this nature, although bonds are included as an asset.

Choosing Components
Since there's millions of possible groups with this many components, I just ran a macro overnight to construct random groupings and save the ones with low average correlations. Virtually all of the low correlation groups include long bonds and gold, and most include one of the two commodity indices and the currency index. I wound up using the CCI - Continuous Commodity Index, which is available as an ETF from Greenhaven (Amex:GCC) and tracks an equal-weight basket of around 20 commodities. Relative to other commodity indices, it's very heavy in agricultural products (especially 'softs', such as sugar, coffee, cotton and orange juice) as well as precious metals and very light in energy and industrial metals. The Reuters/CRB currency index isn't available as a single ETF, but the five component currencies (GBP, EUR, JPY, CHF, CAD) are, and it isn't frequently chosen, for what that's worth.

I wound up analyzing four baskets:

The seven element basket I used consisted of the S&P 500, Hong Kong, Spain, gold, bonds, commodities and currencies. These had an average correlation of 0.117, with the highest correlation being 0.441 between gold and CCI. (Similarly low correlations were available by swapping Hong Kong and Singapore, and/or by swapping Spain with Italy or Sweden.)

The ten element basket I used had an average correlation of 0.1802. Components were S&P 500, US Small Cap, Japan, Singapore, Spain, Italy, gold, bonds, commodities and currencies. US Small cap is from French's web site, and is defined as the smallest 30% by market cap -- as of Dec 2007, the cutoff would be about $1 B, so it's somewhat smaller than, say, the Russell 2000, but larger on average than microcap.

I also considered an 11 element basket, comprised of S&P 500, Japan, Canada, UK, France, Germany, Asia Pacific (ex Japan) and our old friends gold, bonds, commodities and currencies. Correlation is much higher; 0.259 overall and 0.464 for the seven equity markets, but the condolence is that this represents the major stock markets of the developed world and around 65% of total global equity capitalization (and as recently as 2002 represented almost 80%).

Performance
In each case, I'm comparing the historical performance of the RtW strategy on the selected basket with three other values: the S&P 500, the basket components equally-weighted, and the equity components of the basket (since the diversifying elements like gold and bonds tend to reduce return). I think the latter is the best benchmark; a strategy involving switching in and out of a handful of equities should surely beat buy and hold.

7 element basket (S&P 500, Hong Kong, Spain, Gold, 10-yr Bond, Currencies, Commodities)

Annual returns:
All 7 Equity Mkts
Year Top 1 Top 2 Equal-Weight Equal-Weight S&P 500
1978 2.2% 11.4% 17.4% 14.7% 1.1%
1979 79.8% 67.5% 32.6% 30.3% 12.3%
1980 5.4% 28.7% 19.5% 32.9% 25.8%
1981 -0.7% 1.4% -7.4% -1.4% -9.7%
1982 0.9% 21.0% -8.6% -22.1% 14.8%
1983 -20.2% -3.2% 4.7% 7.1% 17.3%
1984 29.3% 15.8% 5.7% 27.2% 1.4%
1985 59.3% 28.5% 22.3% 44.4% 26.3%
1986 115.1% 55.0% 28.9% 61.2% 14.6%
1987 -13.2% 3.5% 18.9% 15.6% 2.0%
1988 24.5% 6.1% 6.5% 17.3% 12.4%
1989 12.1% 13.7% 7.3% 19.8% 27.3%
1990 -3.4% -8.9% 2.5% -0.3% -6.6%
1991 31.9% 21.3% 11.2% 30.8% 26.3%
1992 30.2% 16.3% 1.0% 5.2% 4.5%
1993 50.8% 45.4% 24.3% 46.5% 7.1%
1994 -19.8% -21.1% -1.9% -10.7% -1.5%
1995 13.6% 17.5% 14.0% 28.9% 34.1%
1996 22.1% 13.8% 12.0% 31.3% 20.3%
1997 0.0% 1.8% -0.6% 7.9% 31.0%
1998 29.2% 18.6% 9.3% 24.1% 26.7%
1999 20.5% 14.5% 12.0% 24.0% 19.5%
2000 -22.9% -18.3% -3.7% -10.3% -10.1%
2001 -5.6% -7.8% -7.8% -13.1% -13.0%
2002 5.2% 1.0% 1.6% -15.8% -23.4%
2003 30.5% 36.6% 24.1% 41.4% 26.4%
2004 19.4% 13.4% 13.0% 20.7% 9.0%
2005 15.6% 10.8% 7.4% 5.8% 3.0%
2006 43.4% 28.0% 20.0% 31.0% 13.6%
2007 30.0% 23.6% 17.3% 18.9% 3.5%

CAGR: 16.3% 13.6% 9.6% 15.4% 9.6%
GSD: 26.3% 18.3% 10.6% 19.5% 14.7%
Sharpe: 0.15 0.14 0.12 0.17 0.02

Trailing Years Performance (Top 1 RtW):

CAGR GSD Sharpe
5 years (2003-2007) 27.4% 8.8% 0.44
10 years (1998-2007) 14.9% 20.2% 0.19
15 years (1993-2007) 13.5% 21.4% 0.16
20 years (1988-2007) 14.7% 19.5% 0.17
30 years (1978-2007) 16.3% 26.3% 0.15


10 element basket (S&P 500, US Small, Japan, Singapore, Spain, Italy, Gold, 10-yr Bond, Currencies, Commodities)
					
Annual Returns:
RtW RtW All 10 Equity
Year Top 1 Top 2 Equal Equal S&P 500
1978 -5.0% 11.4% 25.7% 30.1% 1.1%
1979 114.6% 67.5% 23.1% 15.9% 12.3%
1980 26.0% 28.7% 27.4% 40.1% 25.8%
1981 4.1% 1.4% -1.4% 5.9% -9.7%
1982 20.6% 21.0% -1.3% -4.0% 14.8%
1983 -14.1% -3.2% 11.3% 17.6% 17.3%
1984 5.9% 15.8% -1.2% 3.8% 1.4%
1985 72.0% 28.5% 26.2% 40.1% 26.3%
1986 56.5% 55.0% 39.4% 63.6% 14.6%
1987 32.5% 3.5% 14.4% 10.7% 2.0%
1988 3.6% 6.1% 11.9% 21.1% 12.4%
1989 23.4% 13.7% 11.4% 20.7% 27.3%
1990 6.0% -8.9% -7.5% -15.4% -6.6%
1991 14.1% 21.3% 11.3% 20.7% 26.3%
1992 2.7% 16.3% -4.7% -6.5% 4.5%
1993 56.7% 45.4% 21.1% 29.3% 7.1%
1994 -4.3% -21.1% 5.0% 4.9% -1.5%
1995 2.7% 17.5% 11.4% 16.6% 34.1%
1996 9.6% 13.8% 7.6% 13.5% 20.3%
1997 0.1% 1.8% 1.5% 7.3% 31.0%
1998 27.3% 18.6% 12.1% 21.2% 26.7%
1999 42.9% 14.5% 21.7% 35.2% 19.5%
2000 -25.1% -18.3% -8.4% -14.6% -10.1%
2001 0.7% -7.8% -9.8% -13.9% -13.0%
2002 -1.4% 1.0% -1.5% -12.2% -23.4%
2003 27.1% 36.6% 31.5% 45.5% 26.4%
2004 11.1% 13.4% 15.8% 21.6% 9.0%
2005 15.1% 10.8% 9.2% 9.6% 3.0%
2006 40.6% 28.0% 21.3% 27.6% 13.6%
2007 25.4% 23.6% 11.3% 8.1% 3.5%

CAGR: 16.9% 13.6% 10.5% 14.0% 9.6%
GSD: 24.1% 18.3% 12.0% 17.9% 14.7%
Sharpe: 0.16 0.14 0.13 0.16 0.02


Trailing Years Performance (Top 1 RtW):

CAGR GSD Sharpe
5 years (2003-2007) 23.4% 9.7% 0.39
10 years (1998-2007) 14.5% 21.5% 0.18
15 years (1993-2007) 13.4% 20.8% 0.16
20 years (1988-2007) 12.4% 18.2% 0.14
30 years (1978-2007) 16.9% 24.1% 0.16


11 element basket (S&P 500, Japan, Canada, UK, France, Germany, Asia Pacific ex Japan, Gold, 10-yr Bond, Currencies, Commodities)
Annual Returns:					
RtW RtW All 11 Equity
Year Top 1 Top 2 Equal Equal S&P 500
1978 14.5% 12.4% 26.3% 30.4% 1.1%
1979 99.9% 61.4% 25.3% 20.2% 12.3%
1980 -4.4% 17.1% 18.1% 22.8% 25.8%
1981 -18.2% -0.2% -9.0% -7.4% -9.7%
1982 -10.3% 7.1% 0.9% -0.2% 14.8%
1983 -11.6% -7.5% 16.9% 26.0% 17.3%
1984 -6.2% -3.1% -2.8% 0.4% 1.4%
1985 54.5% 51.2% 32.0% 48.3% 26.3%
1986 36.2% 50.4% 30.3% 44.2% 14.6%
1987 7.8% 20.9% 14.2% 10.8% 2.0%
1988 13.2% 17.0% 14.1% 23.5% 12.4%
1989 3.4% 21.2% 15.2% 25.6% 27.3%
1990 -7.6% -6.0% -4.6% -9.8% -6.6%
1991 0.4% 4.6% 10.6% 18.1% 26.3%
1992 -4.2% -5.3% -3.8% -4.7% 4.5%
1993 57.1% 43.6% 22.3% 30.4% 7.1%
1994 -21.9% -6.9% 2.6% 1.2% -1.5%
1995 20.1% 15.0% 12.1% 17.0% 34.1%
1996 9.6% 20.8% 10.3% 17.1% 20.3%
1997 6.4% -0.4% 1.4% 6.5% 31.0%
1998 26.2% 28.8% 10.1% 16.9% 26.7%
1999 39.1% 43.1% 24.1% 37.2% 19.5%
2000 -5.5% -6.2% -6.1% -10.3% -10.1%
2001 -7.3% -12.5% -13.0% -18.1% -13.0%
2002 20.0% -0.5% -5.1% -16.0% -23.4%
2003 36.3% 48.4% 32.0% 44.2% 26.4%
2004 10.7% 9.2% 14.8% 19.2% 9.0%
2005 20.4% 13.7% 12.0% 14.0% 3.0%
2006 25.7% 27.4% 19.8% 24.2% 13.6%
2007 36.6% 28.3% 16.2% 16.2% 3.5%

CAGR: 12.1% 14.8% 10.5% 13.6% 9.6%
GSD: 23.6% 18.8% 12.3% 17.3% 14.7%
Sharpe: 0.11 0.16 0.13 0.16 0.02


Trailing Years Performance (Top 1 RtW):

CAGR GSD Sharpe
5 years (2003-2007) 25.6% 9.3% 0.43
10 years (1998-2007) 19.1% 15.6% 0.29
15 years (1993-2007) 16.5% 19.8% 0.23
20 years (1988-2007) 12.4% 18.7% 0.15
30 years (1978-2007) 12.1% 23.6% 0.11

Interestingly, this third basket seems to perform relatively well out to choosing the top 5 or so ranked components.

Summary, Analysis and Conclusions

The RtW strategies outperformed the S&P 500, in all three baskets of investments. The 10 element basket outperformed the other two, but none of the RtW strategies outperformed an equal weighted investment in the underlying equities -- they had slightly higher CAGRs, paid for with a large increase in GSD.

In all three baskets, the results for the last 5 years were far more impressive -- CAGRs in the mid-20s for GSDs around 9%. However, looking farther back, there was a strong mean reversion type tendency. Also, it turns out that you should have bought gold in 1979.

Personally, this helped to confirm one of my fears about the Moose / RtW approaches. The main suspicion I had is that the massive results are due to a couple of hot picks, like the recent Brazil run up (and, for the Decision Moose, a 95% return in 6 months on "gold share" ASA -- during a period when gold bullion itself went up less than 20%). The baskets I tested on included equity markets from Europe, Asia and America, plus four nonequity components, and had very low correlations overall. The second two baskets, the 10 element basket and what I call the Global 11 had major differences in the equity components (only the S&P and Japan in common), and they provided similar performance, which seems to me like it may be a more believable result than some other outliers.

The new result, though, is the instability. While the baskets presented here didn't produce world-beating results, they still produce respectable results -- for the last 5 or 6 years. But the previous 25 years tell a very different story, and one that's not particularly impressive, in my opinion.

An argument could be made that the new world market is more fluid than it's ever been, that the recent outperformance of this strategy is something that's likely to continue. But if I had a dollar for every time I heard that it's different this time, well, I'd have enough money to make up my losses from all the times I thought it was different this time.

Kevin :)

Data sources:
Kenneth French - http://mba.tuck.dartmouth.edu/pages/faculty/ken.french/data_...
Ohio State - http://www.cob.ohio-state.edu/~fin/resources_data/data/spind...
S&P - http://www.google.ca/url?sa=t&ct=res&cd=3&url=http%3A%2F%2Fw...
Wren Investment Advisers - http://www.wrenresearch.com.au/downloads/index.htm
CRB - http://www.crbtrader.com/crbindex/default.asp

PS: Corrections, comments and questions are, of course, very welcome; however, I'm likely to be busy at work over the next couple of days, and out of Internet distance over the weekend. Sorry in advance for any delays in response.
Print the post  

Announcements

What was Your Dumbest Investment?
Share it with us -- and learn from others' stories of flubs.
When Life Gives You Lemons
We all have had hardships and made poor decisions. The important thing is how we respond and grow. Read the story of a Fool who started from nothing, and looks to gain everything.
Contact Us
Contact Customer Service and other Fool departments here.
Work for Fools?
Winner of the Washingtonian great places to work, and Glassdoor #1 Company to Work For 2015! Have access to all of TMF's online and email products for FREE, and be paid for your contributions to TMF! Click the link and start your Fool career.