How effective is the strategy?

Since price history on ETFs is limited, it is not possible to run a 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 is 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. Before the iShares Small-Cap Russell 2000 was traded, the backtest bought the Russell 2000 index.

The strategy is designed to rotate to the segments of the market that have the best performance. During the bullish years, returns were led by the strength of the Nasdaq 100 (QQQ) holding. During the bearish years, the portfolio outperformed because it exited the QQQ and rotated to a position in Small-Cap Value (IJS). Small-cap stocks actually rose in value during 2001.

Over the 6 1/2 year time period, the Style Index portfolio strategy rose 146% while the S&P 500 and Nasdaq Composite rose about 30%. The year-by-year results are found in Table 1. The strategy outperformed the S&P 500 index every calendar year and it held its value during the 2000 through 2001 bear market years. It wasn’t until the third quarter of 2002 that all style indexes fell in value, accounting for the 2002 loss. An investor should not expect the strategy to rise in value during a falling market. Keep in mind that this is a backtest so it does not represent actual returns.