Equity Curve Trading

In 2006, Cambria Investment Management published a paper that gained wide spread popularity where it proposed that applying a long term 10 month SMA to assets classes (rules below) to trade them would effectively cut the drawdown while preserving the equity like return. Such a simple trend following method paired with ease of access to exchange traded funds for exposure has helped made the idea very popular.

I proposed a similar idea. Instead of applying a SMA to the asset classes, one would instead calculate a X month SMA of a buy and hold strategy’s equity curve. If the equity curve ever dips below the equity curve SMA, we will go to cash. In effect we are forming a hedge against our own equity curve.

Below are the results for trading the S&P 500 Index, ETF data are limited so I used underlying total return index as proxy. Data from 1988 to 2011 are total return, but 1970 to 1988 are normal composite data. I know that the numbers are probably a bit off and one should take it as instructive purposes.Test duration are from 1970 to 2012 (May). No commission or slippage accounted for. All signals are taken the following days open.

Th equity curve in the above image shows that it has avoided the last two major bear markets. It preserves return through being on the sidelines.

The above Drawdown for the entire test period confirms that the strategy is able to weather storms! Below is the rolling 10 month return of the strategy. You can see that it replicates the upside buy and hold return very well while. Pretty consistent across time.

I believe that there can be a lot of ideas that can be paired with this method. One such extensions I dreamt about was using traditional methods of portfolio optimization to form portfolio of assets that meet criteria like Minimum variance or risk parity. Overlay this method to only participate in the upside and staying in cash or investing in bonds when equity curve is below its SMA. You are bounded by your own imagination.

 

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