Active Management of the Rydex Sector Funds Abstract The paper presents a simple method of active management of the

Rydex sector mutual funds. It is a group of sixteen funds that began trading in 1998, and like most Rydex funds, there are no restrictions on the frequency of trading or any penalty charges for short holding periods. The underlying concept is to buy the fund that recently has been the weakest performer of the group using a standard technical indicator, the Commodity Channel Index (CCI), hold it for a few days, and then exchange to the fund that has become the weakest. The steps of the development of the trading method are shown, which includes a mechanism to control risks based on the systems equity curve to indicate when to stop and then resume trading. Since the current secular bear market started in 2000 and the Rydex sector funds have existed since 1998, the analysis and system development are based on 2000 through 2010. The first step demonstrates that buying the sector fund with the lowest CCI is a viable concept by comparison to owning the one with the highest CCI. Next the first two parameters are found. They are a 16 day moving average in the CCI calculation and a three day minimum holding period for the fund purchased. These are determined simultaneously using the Ulcer Performance Index (UPI) as the measure of merit. The performance of the basic system using these parameters is examined, and while the investment return is outstanding, the drawdowns are too large for most traders to accept. As a method to control risk, we find when to cease trading the system using a simple moving average crossover based on the basic systems equity curve. The parameters of the crossover are 20 days for the shorter one and 100 days for the longer one. These values are determined holding the basic system parameters (16 and 3 as explained above) constant. In effect, the moving average crossover serves as a filter for the basic trading system. The performances of the active management methods are compared to four methods of passive managementan index fund, the daily average performance of all the sector funds, passive asset allocation with the benefit of hindsight, owning the best performing sector fund each yearand shown to be superior to all but the last one, which requires perfect forecasts of the best performing Rydex sector fund for eleven consecutive years. A compelling argument for the wisdom of active management results from the far superior investment returns and much lower risk levels of the trading system in comparison to passive asset allocation, even when it has the benefit of
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hindsight. For that test, four not highly correlated sector funds with the highest returns over 2000-10 were assumed to have equal dollar amounts invested in them at the start of 2000 and rebalanced to equal dollar amounts at the end of each year. Such a process is typical of the investment advice given by mainstream experts. The trading system is virtually equal in performance to owning the best performing sector fund each year, which is another demonstration of the value of active management. While no person or system is going to pick the sector fund with the highest return every year or even most years, using a fairly simple trading system can result in comparable levels of return and risk. In this sense, active management can make up for the lack of a crystal ball. Next, some additional topics are discussed. One concerns how much confidence we can have that the trading method, which was created by backtesting 2000-2010 data, will perform well in real time. While it is too soon to make a determination, for six years the author has traded the Rydex sector funds using a more complex system based on buying the one with the lowest CCI and holding it for a minimum of a few days. The results have been quite satisfactory. Two other ways of system development are discussed next: walk-forward testing and trying to optimize the four of the parameters mentioned above all together rather than two at a time as was done. Neither of these was pursued, and the primary reasons are discussed. Another topic is an exercise to demonstrate the utility of active management and the applicability of the trading method to a different asset class. The development process employed to determine the trading system for the sector funds is applied to a group of single country exchange traded funds. The resulting trading system with the same structure, but different parameters, outperforms the two passive methods used for comparison by a wide margin.

Introduction After the debacle in stock prices in 2007-09 that saw the S&P 500 Index fall by over 50%, all NAAIM members and a large portion of the investment management community know that active management of portfolios is far superior to buy and hope even with tweaks such as periodic rebalancing. There are quite a few effective methods of active management. Perhaps the most popular one and the one most written about is trend following. Often that method is combined with another idea to make it even more effective. One notable example appears in the winning paper of the first Wagner competition. It enhances trend following with the addition of mean reversion. It is worth noting that there are many ways to skin the cat using active management. This paper presents one that is quite different from trend following and applies it to the Rydex sector funds. It shows that there is no magic formula when it comes to active management; there are many approaches that will work if they have sensible formulations and are carefully researched and tested. The essential idea behind the approach presented is that a sector fund that has recently been the weakest performer in a group of them may well be temporarily out of favor or oversold in comparison to the others in the group. If so, owning such a fund for a few days can take advantage of a likely rebound and the expectation that it will do better over the period than the typical sector fund in the group.

Sector funds are not diversified, so they usually are more volatile than broad market measures such as the S&P 500. If the fund is gaining, the higher volatility should result in greater profits than the broad market. However, during weak markets, sector funds tend to fall more than the popular indices. Moreover, the weakest sector funds are quite likely to suffer substantial and painful gains when stocks are trending down. Accordingly, the general approach described above calls for a risk control mechanism to prevent drawdowns that are too large to make it practical no matter what the level of longer term investment returns. There are many, many technical indicators that can be applied to decide when and in what direction to trade. The book, The Encyclopedia of Technical Market Indicators by Robert Colby (McGraw Hill, 2003) contains almost 800 pages in its comprehensive listing. The author of this paper did not try to test a variety of them. Rather one that felt right for the approach described above was chosen and tested. As it turned out, using the Commodity Channel Index (CCI) led to a trading system the author found to be quite desirable. Another standard indicator, a moving average crossover applied to the systems equity curve, proved to be an effective risk control method.

Preliminary Topics: Rydex Sector Funds, Commodity Channel Index There would be little point in trying to apply the approach described above on a group of funds with similar holdings. What is desired is a set in which some of the funds have the potential to perform quite differently at times than most of the others. With the anticipated short holding periods, being able to move from one fund to another with minimal or no cost is another needed feature. The latter essentially requires using funds in the same mutual fund family that can be traded frequently without costs or penalties. One of the few groups that fits the description is Rydex sector funds. Table 1 lists the ones used here. There are two other Rydex funds that could be considered sector funds: Precious Metals (RYPMX) and Real Estate (RYHRX). They were not included because they are not sectors of the economy in the sense the others are. In addition to the sixteen funds in the table, the Rydex U.S.
TABLE 1 RYDEX SECTOR FUNDS Fund Start Date Banking April 1, 1998 Basic Materials April 1, 1998 Biotechnology April 1, 1998 Consumer Products July 6, 1998 Electronics April 1, 1998 Energy April 21, 1998 Energy Services April 1, 1998 Financial Services April 1, 1998 Health Care April 17, 1998 Internet April 5, 2000 Leisure April 1, 1998 Retailing April 1, 1998 Technology April 14, 1998 Telecommunications April 1, 1998 Transport April 2, 1998 Utilities April 4, 2000

Ticker RYKIX RYBIX RYOIX RYCIX RYSIX RYEIX RYVIX RYFIX RYHIX RYIIX RYLIX RYRIX RYTIX RYMIX RYPIX RYUIX

Government Money Market Fund (RYMXX) was in the database for the times when no sector fund is owned. Despite its name, the Commodity Channel Index (CCI) is applicable to any tradable security. Its typical application as described in the Colby book (p. 1553

158) is as a momentum indicator designed into trade breakouts to periods of expected strong or weak performance. The approach here uses it in a quite different manner: to identify the sector fund that has been the weakest recently as indicated by the lowest CCI reading among the group. The formula: CCI(n) = (P MA(n))/(0.015*D) where P = price of the fund1 MA(n) = simple moving average of last n days prices D = mean of the absolute values of (P-MA(n)) 0.015 is a standard scaling factor that does not affect the method presented here

According to Colby, the normal use is to buy long when CCI exceeds 100 and sell when it falls below that level; sell short when it falls below -100 and cover when it exceeds that level. The 0.015 is needed to make those values effective. It has no effect on which fund has the lowest CCI at any time. The concept behind the CCI is determining when the instrument is making an unusually large move, in either direction, away from its average behavior relative to the moving average. A reading above 100 or below -100 indicates positive or negative momentum that is increasing in the indicated direction. The fund with the lowest CCI can be either the one with the greatest negative momentum, when its CCI reading is less than zero, or the one with the weakest positive momentum when all of the funds in the group have a positive CCI. In either case, it has the weakest recent performance of the group as measured by the indicator.
1

For a security traded during the day, instead of the closing price, the average of the high, low, and close would replace P.

Trading System Development Since regular mutual funds are priced once a day at the close, the computation of the CCI and subsequent determination of the fund with the lowest one can only be done after the market has closed. Consequently, any practical trading system using the approach of this paper requires next day trading. In the testing and reporting that follows, it is assumed that orders to buy, sell, or exchange Rydex sector funds are executed at the NAVs on the market day following the one that generated the signal. As Table 1 shows, the first Rydex sector funds began trading in April 1998, and by the end of that year there were 14. Two more were added in April 2000. We are in a secular bear market that began in 2000, and the typical ones last 16-20 years, so the current one figures to be around for at least another five years. In a secular bull market, buying and holding as well as the most aggressive forms of trading and investing do well. It is in the secular bear markets that the benefits of active management come to the fore. By controlling risk levels, it enables investors to stick to their plans and maximize their chances of reaching their financial objectives. With the secular bear market in mind, I decided to focus the system development on 2000-2010. The returns and other measures shown below cover that period. The first thing to check is that buying the sector fund with the lowest CCI has the potential to be the basis of a profitable trading system. Why not own the one with the highest CCI? By that measure, it has the most upside momentum of
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the group, so it might be a better one to own. Tables 2 and provide the answer. They show the results of holding the Rydex sector fund with the lowest CCI based on the previous days close, trading every day if necessary, and for holding the one with the highest.
TABLE 2: 2000 - 2010 ANNUALIZED RETURNS AND MAXIMUM DRAWDOWNS WHEN HOLDING THE RYDEX SECTOR FUND WITH THE LOWEST CCI CCI Compound Maximum CCI Compound Maximum CCI Compound Maximum length (n) Return Drawdown length (n) Return Drawdown length (n) Return Drawdown 3 5.7% -65.7% 10 10.6% -72.0% 17 15.9% -60.4% 4 3.1% -67.9% 11 11.5% -69.0% 18 16.9% -60.8% 5 12.8% -44.2% 12 13.1% -63.5% 19 13.4% -71.5% 6 15.0% -53.4% 13 14.8% -56.9% 20 12.3% -72.3% 7 11.4% -65.5% 14 10.8% -59.8% 21 8.9% -75.8% 8 9.3% -67.5% 15 17.1% -52.5% 22 9.3% -74.8% 9 11.5% -67.9% 16 17.5% -61.0% 23 8.5% -71.3%

TABLE 3: 2000 - 2010 ANNUALIZED RETURNS AND MAXIMUM DRAWDOWNS WHEN HOLDING THE RYDEX SECTOR FUND WITH THE HIGHEST CCI CCI Compound Maximum CCI Compound Maximum CCI Compound Maximum length (n) Return Drawdown length (n) Return Drawdown length (n) Return Drawdown 3 -12.4% -91.9% 10 -4.2% -81.2% 17 -3.8% -81.3% 4 -8.8% -85.9% 11 -1.0% -74.3% 18 -3.2% -76.2% 5 -7.3% -86.5% 12 0.3% -80.0% 19 -1.8% -76.8% 6 -6.6% -83.9% 13 0.3% -77.1% 20 -2.6% -72.9% 7 -3.4% -81.9% 14 -1.4% -80.7% 21 -0.1% -68.7% 8 -4.6% -78.8% 15 -2.3% -80.4% 22 1.8% -63.1% 9 -6.0% -84.2% 16 -2.7% -78.5% 23 0.6% -67.8%

The left columns in the groups of three in each table show the length of the moving average used in the CCI calculations. Higher values were also tested, but they did not have returns or drawdowns as favorable as the better ones in the table. For each moving average length, owning the lowest ranked fund by the CCI had a much better return than the one with the greatest CCI. Except for a few with longer lengths, the drawdowns were substantially less for the lowest CCI.

The drawdowns are uncomfortably high for all the cases shown. While the tables favor owning a fund with the lowest CCI, perhaps selling it as soon as it is no longer the lowest is not the best way to go. The thinking is that we are buying a relatively week performing fund compared to the others in the group expecting it to rebound, but that rebound may take a few days to be seen. It is worth testing to see if imposing a minimum holding period can improve both the rate of return and reduce the maximum drawdown. An important question when developing a trading system is what measure of merit to use when evaluating the possible methods. Naturally, we want higher expected returns, but achieving those may entail levels of risk that are so large as to make actually trading the system impractical. In other words, there is often a trade-off between potential profits and risk levels. Using an evaluation measure that takes into account both returns and risk levels is an excellent way to handle the trade-offs. There have been books written2 on how to develop trading systems and choose an appropriate measure of merit. I decided to use a risk-adjusted return. The return is the 2000-2010 annualized return, but what measure of risk is to be incorporated? Maximum drawdown captures the worst case scenario, but is not the best way to measure risk levels over an eleven year period. I decided to use the Ulcer Index as the risk measure. It takes all drawdowns into account as well as their prevalence. It is calculated as the square root of the average of the squared
2

Two are Howard Bandys Quantitative Trading Systems (Blue Owl Press, 2007) and Robert Pardos The Evolution and Optimization of Trading Systems (Wiley, 2008).

periodic drawdowns, the period being one day in our case. Like the more common standard deviation, which has a similar type of calculation, lower values indicate less risk. Replacing standard deviation in the well-known Sharpe Ratio by the ulcer index produces the Ulcer Performance Index (UPI), which is the measure of riskadjusted return that I will use in what follows. Taking the above into account, the next step is to find the UPI for various combinations of the CCI moving average length and the minimum holding period (in days) once a sector fund with the lowest CCI is purchased. Table 4 shows the results:

TABLE 4: ULCER PERFORMANCE INDEX WHEN OWNING FUND WITH LOWEST CCI Minimum holding period (in market days) 2 3 4 5 6 7 8 9 10 Length 3 0.36 1.53 0.29 0.29 0.14 -0.12 0.27 0.10 -0.09 of 4 0.19 1.56 0.50 0.31 0.75 0.57 0.13 -0.12 0.03 moving 5 0.94 1.43 0.24 -0.12 0.55 0.85 0.27 0.28 0.32 average 6 1.34 1.60 0.56 1.17 -0.09 0.45 0.24 0.20 0.35 in CCI 7 0.24 0.52 0.62 1.18 0.13 -0.03 -0.03 0.39 0.32 (days) 8 0.11 0.92 0.89 -0.13 0.11 0.05 0.18 0.44 0.18 9 0.40 0.81 0.84 0.34 0.68 0.24 0.34 0.20 0.19 10 0.49 0.50 0.55 0.62 0.01 0.22 0.49 0.30 -0.06 11 0.90 0.89 0.59 0.18 0.36 0.23 0.18 0.24 -0.04 12 0.83 1.19 0.47 -0.11 0.53 0.22 0.07 0.11 0.25 13 1.01 0.55 0.24 -0.01 0.41 0.07 0.29 0.17 0.11 14 0.62 0.92 0.27 0.07 0.13 0.03 0.16 -0.12 0.00 15 1.82 1.96 0.77 0.44 0.72 -0.11 0.17 -0.09 0.10 16 1.32 2.08 0.35 0.37 -0.02 0.00 0.16 -0.11 0.21 17 1.22 2.10 0.48 0.21 0.07 0.05 0.06 0.01 0.22 18 1.30 1.68 0.30 0.04 0.15 0.12 0.15 -0.02 0.17 19 0.67 0.35 0.17 0.14 0.26 0.09 0.12 -0.10 0.00 20 0.52 0.07 0.24 0.22 0.13 0.02 -0.05 -0.08 -0.01 21 0.35 0.17 0.17 0.15 0.00 0.05 -0.07 -0.06 -0.04 22 0.35 0.16 0.07 0.20 -0.03 -0.01 -0.11 -0.10 -0.15 23 0.52 0.50 -0.03 0.01 -0.07 0.01 -0.14 -0.10 -0.15 24 0.55 0.37 -0.09 0.01 0.41 0.06 -0.07 -0.18 -0.09 25 0.31 0.28 -0.02 -0.07 0.03 -0.04 -0.11 -0.20 0.06

The boxed area is the sweet spot of the table. All of the values in it are larger than most of the other entries. The drop-off once the minimum holding period gets larger than three days is notable. The table is telling us that a moving average of 15-18 days combined with a two or three day minimum is the best way to go. I decided to use a 16-day moving average in the CCI and a three day minimum holding period. Its UPI is slightly lower than the 17 and 3 value, but the drop-off is larger going from 17 to 18 than for 16 to 15 days. I suspect that any combination in the boxed area would lead to a trading model nearly as effective as the one in this paper. Buying the Rydex sector fund with the lowest CCI(16), holding it for at least three market days and exchanging to the new lowest one after three or more days (all trading on a next day basis) results in the following statistics for 2000-2010. The compounded annual rate of return is 28.2%, the ulcer index is 12.6%, and the UPI is 2.08. Even with those nice numbers, the maximum drawdown is 49.7% on November 20, 2008. That value is too large for most traders, investors, and money managers. One way to deal with it is to limit exposure to sector fund trading, which is generally a good idea due to the volatility of such funds. Even if the effect on the entire portfolio is not all that painful, it is extremely hard to stick to a trading method that can suffer a hypothetical, backtested drawdown that large. I will discuss how to reduce that measure of risk a little later. Before doing so, lets take a look at the annual performance of the system in order to get a better feel for it. Table 5 shows the yearly returns and maximum drawdowns (starting
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fresh at the beginning of each year). Since the Rydex sector funds began trading in 1998, I included 1999 in the table although it was not included in the system development testing shown above. For comparison purposes, the table also shows the comparable data for the Vanguard Index 500 fund (VFINX) that closely tracks the S&P 500 with dividends reinvested and the daily average performance of all of the Rydex sector funds. The latter is equivalent to a hypothetical fund that owns all sixteen of the funds in equal dollar amounts and rebalances every day. It is also the same as the statistically expected performance of owning a randomly chosen sector fund each day. I include it to show that the performance of the system being
TABLE 5: PERFORMANCE OF TRADING SYSTEM & "RIVALS" Trading System VFINX Avg. sector fund 2000-10: 28.2% 0.3% 2.0% Ulcer Ind: 12.6% 23.6% 22.8% UPI: 2.08 -0.07 0.00 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 Return 26.4% 92.9% 50.5% 48.7% 55.0% 25.5% 7.0% 5.8% 22.8% -21.5% 27.8% 31.0% Max DD -23.9% -17.6% -35.7% -27.3% -11.5% -15.9% -14.6% -15.7% -10.9% -49.7% -33.4% -13.8% Return 21.1% -9.1% -12.0% -22.1% 28.5% 10.7% 4.8% 15.6% 5.4% -37.0% 26.5% 14.9% Max DD -11.9% -17.3% -33.5% -34.8% -12.9% -11.7% -7.9% -11.3% -10.5% -49.0% -24.6% -16.3% Return 26.3% -4.4% -14.4% -21.8% 33.8% 12.6% 7.8% 11.4% 5.1% -36.2% 35.6% 17.5% Max DD -11.8% -16.5% -29.2% -33.0% -13.8% -7.5% -7.0% -7.5% -9.9% -47.7% -27.2% -15.7%

developed is not due to being lucky by choosing from an exceptionally strong performance group. The top three rows show the compounded rate of return for
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2000-2010, the ulcer index, and ulcer performance index3 for that period. Active management using the trading system is far superior to buy and hope as represented by the index fund. Not surprisingly, the average Rydex sector fund is not much better than the index because as a group those funds encompass a broad swatch of the market. In most years the trading system significantly outperformed the other two. The year in which it was a laggard was 2006. Its only losing year was 2008, which shows the market crash from mid-2007 until early 2009 were of a different nature than the 2001-02 plunge. Risk Control Table 5 shows that the trading system is far superior to buy and hold as represented by the Vanguard index fund or by owning an average or randomly chosen Rydex sector fund. However, most money managers and individual traders would not be willing to trade it as shown there. The problem is that there are uncomfortably large drawdowns. The worst, in 2008, was nearly half the value of the equity. Two other years, 2001 and 2009 saw drawdowns within the year of more than a third of the assets. I believe the most important purpose of active management is keeping risks to levels that are acceptable. What is acceptable clearly varies by individual and portfolio managers circumstances, but if the drawdowns are too large for comfort, then the trading or investing method will be abandoned at least temporarily. Being

The risk-free rate of return for the period is that of the Rydex U.S. Government Money Market fund, which was 2.0%. The T-Bill rate was a little higher, so using in the UPI calculations would have lowered them by a small amount, but not affected the comparisons.

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able to stay with ones investment plans greatly increases the chances of achieving financial goals. In short, active management can greatly increase the probabilities of reaching financial goals. There are a variety of risk control methods. One is using an external timing model, of which there is no shortage, to decide when to follow the system and when to move to cash equivalents. I do not think that is a good way with the lowest CCI system because the system has the ability to do well even when the broad market is faltering. As a simplistic example, suppose we had a crystal ball that would tell us whether the S&P 500 was going to be up or down in the coming year. If we applied its perfect predictions, as can be seen in Table 5 the CCI system would not have been followed in 2000, 2001, 2002, and 2008. The last of these was the only year the system lost money, and in the first three years it had huge profits. The method I prefer is to let the system itself tell me when I should stop trading it and when I should resume trading. There are many ways that can be done, and I examined only a few of them. My goal was to use one that was simple and easy to understand. It is possible that a more sophisticated one compared to what is shown below would be more effective. That research, either by the author or someone else, can wait.

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The method chosen is a simple moving average crossover based on the trading systems equity curve,4 which is computed even when actual trading has
TABLE 6: UPI WHEN TRADING SYSTEM AC CORDING T O MA CROSSOVER Length in days of short simple m oving average 5 10 15 20 25 30 35 40 Length 5 of long 10 0.46 m oving 15 0.32 0.71 average 20 1.23 1.02 0.91 25 1.45 1.21 0.77 0.70 30 1.34 0.95 0.48 0.75 0.98 35 1.65 0.77 0.95 1.31 0.94 0.90 40 1.44 0.84 1.27 1.28 1.24 0.79 1.20 45 1.34 1.08 1.39 1.50 1.13 0.83 1.59 1.94 50 0.91 1.46 1.29 0.96 1.21 1.53 1.55 1.73 60 1.22 1.30 1.51 1.18 1.27 1.29 1.31 1.81 70 1.31 1.18 1.37 1.57 1.34 1.39 1.63 1.65 80 1.01 1.04 1.16 1.56 2.02 1.70 1.54 1.37 90 1.22 1.12 1.26 2.21 2.12 1.60 1.12 1.15 100 1.33 1.29 1.66 2.58 1.95 1.26 1.28 1.47 110 1.11 1.35 2.04 2.23 1.19 1.06 1.27 1.35 120 1.33 1.64 1.94 1.44 1.51 1.20 1.48 1.59 130 1.64 1.61 1.68 1.50 1.27 1.43 1.59 1.33 140 1.44 1.38 1.68 1.75 1.41 1.49 1.40 1.56 150 1.50 1.52 1.69 1.39 1.29 1.57 1.71 1.92 160 1.53 1.53 1.78 1.51 1.45 1.51 1.30 1.55 170 1.33 1.51 1.56 1.60 1.52 1.40 1.12 1.42 180 1.08 1.26 1.51 1.46 1.73 1.55 1.39 1.70 190 0.98 1.25 1.51 1.50 1.72 1.37 1.53 1.76 200 1.12 1.50 1.55 1.55 1.49 1.31 1.59 2.26

stopped. In Table 6, the measure of merit is still the UPI and the parameters determined above16 day moving average in the CCI and three day minimum holding perioddo not change. In other words, the optimization of the moving average crossover parameters is subsequent to and does not affect the determination of the CCI trading ones. The boxed area contains most of the better UPI readings although some of the ones in it are not particularly impressive. It suggests that a relatively slow crossover method is best, with a short average of
4

The equity curve calculations start at the beginning of 1999 so there is a full year of initialization prior to the moving average testing.

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15-25 days and a long average of 80-120 days. I did not test intermediate values not shown in the table (e.g. 17 and 93 days) because I would not have any more confidence in such fully optimized parameters than the ones shown in the table. Choosing the ones with the highest UPI, 20 days and 100 days, appears to be the best choice. The UPI is much better, 2.58 vs. 2.08, than the one for the trading method without the moving average crossover filter. Next, we look at the effects on investment returns and drawdowns of the application of the MA crossover. Table 7 below repeats data in Table 5 and adds information about the lowest CCI system filtered by the 20/100 MA crossover (trade the system when the 20 day simple moving average of the equity curve is above the 100 day MA). It also has two additional rows at the top showing the maximum drawdown in 2000-2010 and its date.
TABLE 7: PERFORMANCE OF TRADING SYSTEM, "RIVALS", & WITH 20/100 MA FILTER 2000-10: Max DD: date of: Ulcer Ind: UPI: 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 Trading System 28.2% -49.7% 11/20/08 12.6% 2.08 Return 92.9% 50.5% 48.7% 55.0% 25.5% 7.0% 5.8% 22.8% -21.5% 27.8% 31.0% Max DD -17.6% -35.7% -27.3% -11.5% -15.9% -14.6% -15.7% -10.9% -49.7% -33.4% -13.8% VFINX 0.3% -55.3% 3/9/09 23.6% -0.07 Return -9.1% -12.0% -22.1% 28.5% 10.7% 4.8% 15.6% 5.4% -37.0% 26.5% 14.9% Max DD -17.3% -33.5% -34.8% -12.9% -11.7% -7.9% -11.3% -10.5% -49.0% -24.6% -16.3% Avg. sector fund 2.0% -53.3% 3/9/09 22.8% 0.00 Return -4.4% -14.4% -21.8% 33.8% 12.6% 7.8% 11.4% 5.1% -36.2% 35.6% 17.5% Max DD -16.5% -29.2% -33.0% -13.8% -7.5% -7.0% -7.5% -9.9% -47.7% -27.2% -15.7% System & MA filter 26.7% 2000-10 -28.7% 9/26/01 9.3% 2.58 Return 92.9% 32.2% 43.3% 60.6% 20.8% 8.3% 10.2% 11.1% -10.0% 41.9% 4.9% Average Exposure 69.5% Max DD Exposure -17.6% 100.0% -28.7% -18.0% -9.8% -8.5% -9.6% -8.5% -12.4% -13.5% -13.8% -21.8% 83.1% 70.6% 91.3% 44.4% 68.3% 57.8% 74.5% 37.5% 63.9% 73.4%

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Compared to the trading system without the filter, the system with the filter has a slightly lower rate of return, 26.7% vs. 28.2%, but much lower risk levels. The ulcer index is about one-quarter lower and the maximum drawdown is quite a bit smaller, 28.7% vs. 49.7%. Moreover, the loss in the only losing year, 2008, is more than cut in half. The downside of the filtering is evidenced by 2010 when the filtered version of the trading system trailed the basic system by 26%. For 2000 through 2009 the two versions had virtually the same compounded rate of return, near 28%. As discussed above, I believe most would not be able to stick with the basic system due to too many major drawdowns. My recommendation to anyone wanting to implement the trading methods described here is either to use the filtered version or to find another method of reducing the risk. To summarize, the system to be implemented is: Buy the Rydex sector fund with the lowest CCI(16) Hold it for a minimum of three market days Once another fund has the lowest CCI(16), exchange to that fund and hold it for a minimum of three days Track the equity curve of the system o When the 20 day simple MA crosses below the 100 day MA, move to cash o Resume trading when the MA(20) crosses above MA(100)

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The graph shows the unfiltered equity curve (black line) and the equity curve with the 20/100 moving average crossover (green line). A portfolio consisting of a single sector fund at any time is inherently volatile and is highly unlikely to have a smooth equity curve. That is certainly so for the black line.

FIGURE 1: BASIC AND FILTERED (BY 20/100 MA CROSSOVER), 2000 - 2010 (y-axis is log scale)

13000

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7000 Basic System System filtered by MA crossovers

4000

2500

1000

12/31/99

12/31/00

12/31/01

12/31/02

12/31/03

12/31/04

12/31/05

12/31/06

12/31/07

12/31/08

12/31/09

12/31/10

Using the moving average crossover as a filter, the green line, smoothes it to a considerable extent. I consider it to be an appropriate way to trade sector funds in a risk-tolerant account. Figure 2 on the next page shows much of the data in Table 7 in a graphical comparison of the annual performance of the trading system, filtered and unfiltered, compared the Vanguard Index 500 fund. I believe it makes an extremely strong case for the benefits of active management. In addition to the much lower risk, the trading systems had only one losing year as compared to four for buy and hold. In the years when the index fund had gains, they were generally less than
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FIGURE 2: RETURNS, DRAWDOWNS FOR TRADING SYSTEMS, VANGUARD INDEX 500 FUND
100% Solid Bars - Annual Returns Striped Bars - Max DD in year Green (left) - Filtered Trading System Blue (center) - Unfiltered Trading System Red (right) - Vanguard Fund

80%

60%

40%

20%

0%

-20%

-40%

-60% 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

those of the trading systems. Although not shown in the graph, the theoretical equivalent to buying and holding a Rydex sector fundowning equal dollar amounts in all of them or owning a randomly chosen one each dayperforms similarly to the index fund. Comparison to Passive Methods The author has never put much stock (pun intended) into passive investment methods. In particular, that means not collecting and saving articles about such methods for owning sector funds. One approach that is commonly presented, for more than just sector funds, is to select a few not highly correlated ones to own for a long period of time with periodic rebalancing. Sometimes this method is called passive asset allocation. I will examine how this might have worked for the Rydex sector funds for 2000-10.
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Table 8 shows the annualized return and maximum drawdown for each of the Rydex sector funds in 2000-2010. It shows the same data for the trading system, without and with the moving average filter. We see that none of the individual funds had a rate of return anything close to active management. Only two of them, Consumer Products and Health Care, had maximum drawdowns that were smaller than that of the unfiltered trading system, and those two were still greater than that of the filtered trading system. To formulate the passive asset allocation with rebalancing approach to report on, I am going to cheat and pick four funds with the best returns over the period. The best was Energy, and the second best was Energy Services, which wont be included because of its correlation to Energy. The third best was Basic Materials, the fourth was Health Care, and the fifth was Consumer Products. Those three are not highly correlated with each other, so I will include them in the four funds for passive asset allocation. Note that the two with the smallest maximum drawdowns are included. It is also worth noting that none of the high technology funds is included. I suspect that most anyone picking four funds just before the start of
18 TABLE 8: SECTOR FUNDS 2000-10 RETURNS, DRAWDOWNS Fund Return Max DD Banking -1.6% -79.4% Basic Materials 6.6% -65.7% Biotechnology 1.5% -74.4% Consumer Products 4.2% -39.0% Electronics -7.8% -88.6% Energy 10.0% -64.0% Energy Services 8.8% -71.6% Financial Services -0.5% -76.6% Health Care 4.3% -41.3% Internet -12.0% -92.9% Leisure -0.8% -68.2% Retailing 0.3% -58.3% Technology -6.5% -84.0% Telecommunications -10.7% -87.8% Transport 3.0% -63.5% Utilities 1.1% -61.8% Trading System 28.3% -49.7% with MA filter 26.5% -28.7%

2000 would have included a technology one. We will start with an equal dollar amount in each fund one the last trading day of 1999 and rebalance to equal dollar amounts in the four funds at the end of each year. It would be highly unlikely that the passive allocation using four funds, none of which had a rate of return anywhere close to the trading system, would yield results at all comparable to those of the trading system. In a bit we will see that is the case. To make what should be a more interesting challenge, I will cheat even further by assuming owning only the sector fund with the best return for the year that year. In other words, our crystal ball is so good it will tell us at the start of the year which Rydex sector fund will have the highest return, but not the amount, in the coming year. (If it could tell us the amount, we might decide not to own it if it was going to lose or make too little. There is a limit to how much I am willing to cheat for the test.) For 2000 through 2010 the funds with the best annual returns are Energy Services, Retailing, Banking, Electronics, Energy Services, Energy Services again, Basic Materials, Energy Services, Biotechnology, Electronics, and finally Leisure in 2010. We have two passive methods to challenge the trading system, and both have the advantage of being able to own the funds with the best periodic returns. Table 9 on the next page, which is similar to Table 7, shows the comparisons.

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As anticipated, passive asset allocation does not come close to the trading system. Owning the best fund each year is comparable to the trading system. It is
TABLE 9: PERFORMANCE OF TRADING SYSTEM, PASSIVE "RIVALS", & WITH 20/100 MA FILTER Trading System Passive Allocation Best yearly fund System & MA filter 2000-10: 28.2% 6.9% 29.0% 26.7% 2000-10 Max DD: -49.7% -48.9% -34.9% -28.7% Average date of: 11/20/08 11/20/08 12/1/08 9/26/01 Exposure Ulcer Ind: 12.6% 14.3% 10.0% 9.3% 69.5% UPI: 2.08 0.34 2.70 2.58 Return Max DD Return Max DD Return Max DD Return Max DD Exposure 2000 92.9% -17.6% 5.1% -18.1% 41.4% -30.3% 92.9% -17.6% 100.0% 2001 50.5% -35.7% -7.0% -19.2% 3.2% -28.9% 32.2% -28.7% 83.1% 2002 48.7% -27.3% -12.6% -26.4% -2.0% -28.7% 43.3% -18.0% 70.6% 2003 55.0% -11.5% 27.4% -11.9% 72.7% -20.4% 60.6% -9.8% 91.3% 2004 25.5% -15.9% 18.1% -7.2% 34.7% -12.9% 20.8% -8.5% 44.4% 2005 7.0% -14.6% 13.1% -8.8% 48.5% -15.3% 8.3% -9.6% 68.3% 2006 5.8% -15.7% 14.0% -10.8% 22.1% -16.8% 10.2% -8.5% 57.8% 2007 22.8% -10.9% 21.4% -11.3% 37.4% -14.3% 11.1% -12.4% 74.5% 2008 -21.5% -49.7% -34.7% -48.9% -10.5% -34.9% -10.0% -13.5% 37.5% 2009 27.8% -33.4% 35.1% -20.7% 70.7% -19.1% 41.9% -13.8% 63.9% 2010 31.0% -13.8% 17.7% -14.3% 30.4% -19.4% 4.9% -21.8% 73.4%

interesting that in some years, the trading system makes more than even the best individual sector fund. I believe that Table 9 makes an incredibly strong case for the superiority of active management in a secular bear market. Although the Rydex sector funds have not been around long enough to test during a secular bull market, it is quite likely that active management is superior then, particularly in regard to risk reduction. The two rivals in Table 9 have the benefit of 20-20 hindsight, and as best the author knows, no real person or system has can forecast nearly that accurately. To be fair, the trading system was developed with full knowledge of what happened in 2000-2010, so it benefited in a similar way as the passive cases. The real issue is which method is more likely to produce superior performance in the future. It certainly wont be a method that requires picking the best performing
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sector fund for a year or the four best over a prolonged period. There is no doubt that the active management such as the trading system presented here is by far and away the better choice. The system is simple with just four parameters and has been developed using data from a wide variety of market conditions. While its real time performance is almost certain not to be as good as in the backtesting, it can be expected to produce quite satisfactory trading results, particularly in comparison to passive methods. Additional Considerations 1. How do we know the trading system will work in real time? The acid test of any trading or investing method is real time, out-of-sample experience. Since data through the end of 2010 were used for the testing and development, not enough time has passed yet to make any meaningful evaluation. (For the first two months of 2011, the moving average crossover has been positive and the system has been traded. It is up 5.3%, which trails the index funds gain of 5.9%, but is ahead of the gain of 4.9% for the daily average sector fund/random fund choice.) However, the author has a considerable amount of experience with a similar trading method. A more complex method of trading the Rydex sector fund with the lowest CCI for a short holding period has been used for about six years. Its unfiltered trading rules are more complex than those of the basic system in this paper, and the filter method is based on drawdowns in the equity curve rather than a moving average crossover. So far, the author is quite pleased with the results.
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Wanting to find a simpler system that could be written about in a reasonable length was one of the factors motivating the research presented here. 2. Wouldnt walk-forward testing handle the lack of out-of-sample experience? Both of the authors of the two books mentioned above, Howard Bandy and Robert Pardo, are strong advocates of walk-forward testing and development being the best way to find effective trading systems. There is much merit in what they say, but things are not all that cut and dried. A thorough discussion of that issue is beyond the scope of this paper. However, I will mention a couple of the reasons I did not try walk-forward for the current system. Although walk-forward has some aspects of testing on out-of-sample data, it is not in real time. The reason the distinction is important is that if the walkforward testing leads to an unsatisfactory system due to poor out-of-sample results, the system will be discarded and one that is at least somewhat different will be examined. In other words, it is not truly out-of-sample because the entire data set eventually is used to determine whether or not to give the trading method further consideration or to discard it. A second factor is that walk-forward adds two parameters to the system, so it becomes more complex. If the four parameter system type described above were developed using walk-forward testing, one would need to establish the look back period used to determine the parameters at each phase and the length of the walkforward test period. For example, the parameters might be based on a one year period and tested over the next six months. That means there are really six
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parameters involved. If a test run was not satisfactory, the developer might decide to vary the look back and testing periods, the two additional parameters, before deciding the basic trading model formulation was not viable. As trading system developers well know, the more complex a system is the less likely its real time performance will come close to being as desirable as the backtested results. 3. Did you try to optimize all four parameters as a group? I considered doing so, but decided not to. In effect, I optimized in two stages. The first was to find the CCI look back length and the minimum number of days to hold a fund. The second was to find the filter based on a moving average crossover of the equity curve resulting from the first two parameters. Optimizing all four parameters as a group using UPI as the measure of merit could not yield a lower UPI and likely would result in a higher one. My thinking is that I wanted to find an attractive trading system that could stand on its own. The unfiltered one fits that description if one is quite risk-tolerant. If all four parameters were optimized as a group, the basic two parameter system quite likely would not be as good as the one I developed by itself. If the four parameter optimization resulted in the same first two parameters (16, 3), then the two moving average parameters would also be the same as those I developed (20, 100). If the first two are different and the UPI is higher, then the four parameter optimization is adjusting the moving average crossover to a less desirable basic system. That likely decreases the chances of the trading method working well in real time.
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4. Can the methods work on different groups of funds? In other words, is there something special about (Rydex) sector funds that makes the lowest CCI method effective? One way to attempt to answer the question is to try the approach on a different type of funds. I decided to select a group of 16 single country sector funds and use the technology already developed to see if an effective trading system would result. There are enough iShares MSCI single country ETFs that date back to 1996 to do the testing. Unlike traditional mutual funds such as the Rydex sector funds, trying to trade ETFs using the methods described above has some practical difficulties. The primary one is that one cant exchange directly from one ETF to a different ETF. A sell order for the fund being exited and buy order for the fund being entered are needed. This likely could not be done at the close because the execution prices would not be known, and hence how many shares to buy. Two transactions, the sell followed immediately by the buy, just before the close of trading could come fairly close to a perfect exchange. Since this is a theoretical exercise, I will assume we can exchange from one ETF to another at the closing prices. Because there will commissions for the transactions, I did the analysis with 0.04%5 deducted for each round trip trade. The 16 country funds are Australia, Canada, Sweden, Germany, Hong Kong, Italy, Japan, Switzerland, Malaysia, Netherlands, Austria, Spain, France, Singapore, U.K., and Mexico. For the single fund buy and hope rival, I chose the
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Based on a $50,000 account and $10 per transaction. These are reasonable, but obviously there can be significant differences. The value of the commission charge can affect the parameters found.

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Vanguard Total International Index fund (VGTSX). The other passive rival is theoretical based on the average daily percent change of the sixteen country funds, which is the same idea used with the sector funds. Cash when out of the market would be in the Vanguard Prime Money Market fund. Working as above, I found parameters for the basic trading system of 10 days for the CCI moving average period and a minimum of 5 days to hold the fund purchased. The moving average crossover parameters for the filter are 15 days and 35 days. These values are quite a bit different from those for trading the sector funds. However, that is neither surprising nor a significant concern. There is little reason to think there is a universal set that works well for many classes of assets. As above, the measure of merit is the ulcer performance index for the period 2000 through 2010. Table 10, the equivalent of Table 7, shows how the trading system, basic and filtered, and the two buy and hold rivals fared.
TABLE 10: TRADING SYSTEM on INTERNATIONAL ETFs, "RIVALS", & WITH 15/35 MA FILTER Trading System VGTSX Avg. country ETF System & MA filter 2000-10: 16.8% 3.0% 6.1% 21.7% 2000-10 Max DD: -56.3% -61.5% -58.3% -31.6% Average date of: 3/9/09 3/9/09 3/9/09 8/20/10 Exposure Ulcer Ind: 19.1% 26.5% 20.5% 11.2% 64.5% UPI: 0.73 0.01 0.16 1.68 Return Max DD Return Max DD Return Max DD Return Max DD Exposure 2000 36.2% -24.0% -15.6% -20.1% -10.5% -16.0% 34.0% -17.7% 71.8% 2001 -1.9% -29.1% -20.2% -32.6% -14.3% -32.1% 6.1% -12.4% 51.6% 2002 -8.4% -33.1% -15.1% -27.6% -10.3% -26.8% 12.6% -11.1% 43.7% 2003 21.7% -13.6% 40.3% -15.6% 43.2% -13.1% 24.9% -12.8% 80.2% 2004 15.7% -15.5% 20.6% -10.6% 24.1% -10.8% 10.2% -12.5% 63.1% 2005 27.2% -11.8% 15.6% -7.1% 11.6% -6.6% 21.6% -8.4% 70.6% 2006 47.5% -15.3% 26.6% -16.6% 30.9% -14.7% 51.8% -9.8% 87.3% 2007 21.2% -16.4% 15.5% -12.8% 16.8% -12.2% 5.7% -11.8% 72.5% 2008 -38.9% -54.9% -44.1% -55.9% -40.7% -53.4% 4.2% -15.3% 32.0% 2009 84.9% -30.7% 36.7% -27.7% 38.7% -26.9% 107.0% -21.1% 79.4% 2010 24.2% -21.1% 11.1% -18.6% 11.8% -19.1% -6.5% -31.6% 65.1%

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The overall pattern of the comparisons is the same as for the sector funds with some significant differences. Looking at the first and last group of columns, we see that the moving average filter both greatly reduces the risk levels of the basic system, as was the case for sector funds, and also increases the return quite a bit, the opposite of what happened before. The passive buy and hold alternatives did better than those for the sector funds, but still proved much less worthy than either version of the active management method. Since the trading method would be a hassle to implement using the single country ETFs and I have never attempted to do it, I wont go into more detail or explore the other passive approaches shown for the sector funds. The information shown for the single country ETFs is yet another compelling illustration of the value of active management. 5. With the three day holding period, arent there three streams of investment performance that need to be taken into account? In other words, one could have started by purchasing a Rydex sector fund on any of the last three market days of 1998 in order to be using the system for all of 1999. However, the Energy fund had the lowest CCI for five consecutive days twice in January 1999, so by the end of that month all three of the streams starting in late 1998 would have owned the same fund and continued to own the same fund afterwards. There have been numerous times when a Rydex sector fund had the lowest CCI for five or more days in a row. The analysis and testing to develop the
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trading system start with 2000 performance. By starting the equity curve calculations at the beginning of 1999, there is only one stream of performance involved in 2000 and later. The key is that the three days is a minimum holding period, so some of the trades will last longer, which enables the eventual confluence of the streams. 6. What percentage of the trades are profitable and what are the average returns of the winning and losing trades? This information is less important than what is shown in the tables above, but it does provide more of the flavor of the trading system. For 2000-10 there were 559 sector fund trades in the system with the moving average crossover filter, which does not count the money market ones. Of those, 58.7% showed a profit. The winning trades had an average return of 2.38%, the losing ones averaged -2.24%, and the overall average return per non-money market trade was 0.52%. Table 11 repeats the last three columns of Table 9 and shows the number of trades, the number that gained, the percentage that gained, and the average trade result for each year excluding the money market fund trades.
TABLE 11: TRADING SYSTEM WITH MOVING AVERAGE FILTER Return Max DD Exposure # of trades # up % up Avg. gain 92.9% -17.6% 100.0% 70 42 60% 1.26% 32.2% -28.7% 83.1% 56 37 66% 0.68% 43.3% -18.0% 70.6% 58 33 57% 0.60% 60.6% -9.8% 91.3% 68 43 63% 0.68% 20.8% -8.5% 44.4% 33 23 70% 0.49% 8.3% -9.6% 68.3% 53 29 55% 0.32% 10.2% -8.5% 57.8% 42 23 55% 0.10% 11.1% -12.4% 74.5% 53 27 51% 0.10% -10.0% -13.5% 37.5% 29 15 52% -0.20% 41.9% -13.8% 63.9% 46 27 59% 0.82% 4.9% -21.8% 73.4% 51 29 57% 0.12% 26.7% -28.7% 69.5% 559 328 59% 0.52% Money market trades included Money mark et trades NOT included

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2000-10

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Summary The relatively simple trading systems shown above for the Rydex sector funds and also for a group of single country ETFs show the value of active management. The systems do far better with regard to investment returns and risk levels than the Vanguard broad market index funds that would be typical in buy and hold accounts. Even with being able to know the best funds in advance, passive asset allocation among the sector funds with rebalancing does not come close to the trading systems performance. It takes owning the best sector fund each year, and if that could be done it might be considered to be active management, to get comparable returns and risk measures. So a well designed trading system can be a practical substitute to a highly accurate crystal ball, none of which is known to exist. No claim is made that the lowest CCI method shown above is better than other methods of technical analysis. I would not be surprised if someone else found an even better relatively simple model for trading the Rydex sector funds. Such a model would be yet another demonstration of the value of active management. We are in the midst of a secular bear market and have seen stocks fall by huge amounts twice since 2000. With that in mind, it is an unsolved mystery to me why so many so-called experts still say that active management, which they often describe as market timing, cant be done successfully, so some version of passive asset allocation is the only sensible way to achieve ones financial goals.

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They say that in spite of abundant evidence that passive methods do not work. Fortunately, NAAIM members know better.

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