How Our Models Work

 

As we were managing our clients through the roller-coaster market following the crash of 2007-2008, we began development of a quantitative investment process aimed at outperforming “buy and hold” through a complete market cycle. We sought a process that would:

  • Respond to actual short term trends in sector performance, signaling which sectors are gaining momentum and which are losing ground
  • Provide access to most major asset classes between which large institutional money managers move money, whether they are technical or fundamental analysis-focused
  • Offer trading methodologies that minimize costs and implementation difficulties

Several innovations of the last few years made these goals attainable for a “boutique”, independent investment firm like ours:

  • A wide range of exchange traded funds (ETFs) have evolved to provide efficient, index-access to most major asset classes and sectors, worldwide
  • Vast amounts of historical and up-to-the-minute market and individual security performance data can now be quickly downloaded
  • A variety of relatively inexpensive software was developed permitting extensive data analyses
  • Recent trading platform improvements make it possible to efficiently trade large numbers of shares without transaction costs
"The evolution of exchange traded funds makes it possible for individual investors to succeed in markets heretofore inaccessible to all but the largest institutional traders."

 

Since the first ETF was introduced to U.S. exchanges in 1993, their numbers have exploded (today there are over 1,500 different ETFs holding more than $1.7 T in assets).1

From those funds with a track record, we chose 50 broadly traded fund that provide exposure to most major asset classes…including small, mid and large cap U.S. to emerging markets, currencies, bonds, real estate, commodities and many sub-sectors like biotech or transports. These 50 funds formed our selection universe for all model development and back-testing.

We collected historical daily price and volatility data for all universe constituents starting just before the market's 2007 peak and continuing through today. We formulated and tested scores of different algorithms combining the data in a variety of ways to lead us to mathematical relationships which produced less drawdown and generated full-cycle  out-performance (09/30/07-12/31/13) when compared to the S&P 500 Index. 

We set several objectives in building our models:

  1. We wanted to develop different models that would exhibit at least 3 distinct performance patterns…a “smooth ride” (i.e. low volatility) model, a preservation-growth model and a model that was a blend of the growth and low volatility approaches.…each model suitable for different risk tolerance and investing goals.
  2. We wanted all models to show less “drawdown” (i.e. peak to trough) performance than the overall market
  3. We wanted all models to at least match the overall market's performance through the entire market cycle
  4. Because of the shortcomings of “buy and hold” in today's rapidly trending markets, we wanted our models to be dynamic and responsive, with frequent reallocation.

After thousands of iterations and testing multiple mathematical hypotheses, we eventually settled on 3 different fund selection algorithms which, when applied to actual historical data, produced the 3 different performance “flavors” we sought. We also learned that selecting 4 ETFs from the 50 fund universe for each of the 4 models and reallocating monthly, produced the best outcomes across the entire cycle.

"While trying to time the market is almost always fruitless, frequent reallocation and momentum-based investing both offer potential pathways to success."

 

To summarize, each month, using price and volatility data updated with the prior month's activity, we select 4 ETFs in each of the 3 models…Low Volatility, Value-Growth and Blend. A client's assets are equally divided among the 4 ETFs selected by the model they have chosen in conjunction with their advisor. At the end of the month, the selection process is repeated and money is re-allocated among the 4 funds selected for the next month's holdings. By moving in and out of sectors, the models account for hot sector trends while shedding those that are moving in the wrong direction.


 

1 http://etfdb.com/etf-education/what-is-an-etf/

This information does not purport to be a complete description and is intended for informational purposes only. Any opinions are those of Woodwell Asset Management or John Myers and not necessarily those of J.W. Cole Financial and/or J.W. Cole Advisors, Inc. This information is not intended as a solicitation or an offer to buy or sell any security referred to herein. Investments and strategies mentioned may not be suitable for all investors. You should discuss any tax or legal matters with the appropriate professional. The S&P 500 is an unmanaged index of 500 widely held stocks that's generally considered representative of the U.S. stock market. Indices are unmanaged, do not incur fees or expense, cannot be invested into directly and individual investor's results will vary.