Thursday, April 21, 2011

ETF Ranking

There are two problems with the fundamental ranking system T-Rank 2.0 if one would like to use it as a mechanical trading system: liquidity and volatility. Liquidity is mainly discussed here, and volatility is touched, though lightly, here. I was struggling with them for a couple of days and didn't have any good solution that satisfies me. Then suddenly an idea popped up to me following the discussion with an value investor on something totally irrelevant (it was good discussion and it opened my eyes). I can rank and trade ETFs. The rank of an ETF is the weighted average of ranks of the stocks in its portfolio. ETF hit two birds with one stone: it is naturally diversified, thus less volatility; and it has much better liquidity.

My research tool doesn't support the calculation required by my ETF ranking method. So I couldn't do back test on this. I manually calculated the ranks of the 9 popular sector ETFs: XLB, XLE, XLF, XLI, XLK, XLP, XLU, XLV, XLY, using today's weights and last weekend's stock ranks. Then I relate it to their one week return. Tomorrow the market won't open so today's close is weekly close. The result is charted below.

At the first glance, there is tendency that higher ranked ETF has better return. But the points do not align nicely on a straight line. I looked at it for a couple of minutes and figured out that it is because the offensive sectors vs. defensive sectors. Among the 9 ETFs, 6 are deemed to be offensive, they are B, E, F, I, K, and Y. The rest 3, P, U, and V, are defensive. It appears that offensive ETFs aligns well to a straight line, as well as the defensive ones. The least square fits are plotted on the chart also.

Although I have only one week data, the deviation from the least square fit is minimal and I believe this shows that there is significant statistical link between the ranks of ETFs and their short term return. Two remarks:
  • Offensive sectors and defensive sectors do behave differently.
  • An market neutral strategy is to long the top ranked ETF and short the bottom ranked ETF.

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