Last fall, the National Association of Active Investment Managers (NAAIM) asked me to present to them as a guest speaker on the use of Exchange Traded Funds for “rotational modeling.” Rotation, Momentum or Relative Strength strategies, as they are known, are based on the idea of identifying and owning only the strongest performing segments of the market.
The core concept behind these strategies is as old as Sir Isaac Newton’s falling apple: “A Body in Motion Tends to Remain in Motion.” As it turns out, the physical analogue of momentum directly applies to price action in the stock market. In fact, in the last century a Nobel Prize was awarded to two researchers who identified momentum as an “unexplained” aspect of Efficient Market Theory.
This theory proposes that the price of a stock incorporates all known information at any point in time. In contrast, empirical evidence shows that once stocks and ETFs begin to move in a certain direction, whether up or down, they often continue in that direction for a period of time.
Rotational trading capitalizes on this effect by simply identifying which securities demonstrate the strongest momentum on a comparative basis, and then attempts to ride these successive momentum “waves” to maximize wealth accumulation during a given period of time.
As is often the case, by the time my presentation was due the theme of the conference had morphed, in this case to Risk Management (remember the period right after the U.S. debt downgrade in 2011?). I therefore re-purposed my speaker notes to show how my very same set of approaches could be used with this particular goal in mind. Recalling that my notes were intended for an institutional audience, you may find my slide presentation here, entitled “Using ETF-based Asset Class Ranking Models to Assess Market Risk Acceptance.” I’d be happy to answer your questions about that presentation by e-mail.
Note: Charts and graphs used in the subject presentation are for educational and illustration purposes only, and are not intended to represent ECA’s historical track record.
