This month’s ETFReplay.com Relative Strength ETF Portfolio has been updated at Scott’s Investments and includes turnover in one position.

I previously detailed here and here how an investor can use ETFReplay.com to screen for best performing ETFs based on momentum and volatility. I select only the top ETFs out of a static basket of 25 ETFs and re-balance the portfolio monthly.

The buy/sell strategy for the portfolio is simple: purchase the top ETFs based on a combination of their 6 month returns, 3 month returns, and 3 month volatility (lower volatility receives a higher ranking) and the average of the 3 month return, 20 day return, and 20 day volatility. I refer to these two different sets as “6/3/3? and “3/20/20?. The top 2 ETFs in the 6/3/3 ranking and top 2 in the 3/20/20 ranking are purchased each month. When there are duplicates in the top 2, I look to the third ranked ETF in the 3/20/20 and, if necessary, the third ranked ETF in the 6/3/3. The strategy always holds 4 ETFs.

I track this strategy as a public portfolio on Scott’s Investments. As of the close July 31st the hypothetical portfolio was up 13.60%, since inception on January 1st, 2011. Returns include dividends but exclude commissions and taxes and all trades are hypothetical so real results will differ. For some backtests on these strategies please see a recent post here.

For July 31st the strategy sold its positions in Vanguard MSCI U.S. REIT (VNQ) for a gain of 2%. The proceeds were used to purchase iShares Barclays Long-Term Treasury (TLT). The portfolio also continues to hold iShares iBoxx Invest Grade Bond (LQD), PowerShares Emerging Mkts Bond (PCY) and U.S. Utilities Sector SPDR (XLU).
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The purchase of TLT for this month is noteworthy – long-term interest rates in the United States are near historic lows. More than one market pundit has called for a “bottom” in interest rates since 2008/2009. Holding long-term bonds over the long-term is a scary proposition – rates are bound to increase someday which would cause the value of TLT to drop. However, keep in mind that this strategy is rules-based and rotates between several different asset classes on a monthly basis. Also, when everyone and their grandmother sees a trade as a slam-dunk (in this case shorting bonds), the market will surely take its time in cooperating.

Minor fluctuations in rankings may not always justify selling positions each month. For example, if one ETF drops from the second highest rated to the third or fourth highest rated, it may not warrant selling the position. An investor could only sell a position when it drops out of the top 4 or 5 at the end of the month. This type of modification could be used when someone is looking to limit turnover; however, I think it is important to have whatever rule you prefer to use in place prior to making the investment decision in order to avoid discretionary or emotional decision making.

Below are the top 6 ranked ETFs for this month, using both the 6/3/3 and 3/20/20 strategy:

6mo/3mo/3mo
PCY PowerShares Emerging Mkts Bond (7-9yr)
LQD iShares iBoxx Invest Grade Bond (7-8yr)
XLU U.S. Utilities Sector SPDR
TLT iShares Barclays Long-Term Trsry (15-17yr)
PFF iShares S&P US Preferred Stock Index
IEF iShares Barclays 7-10 Yr Treasury (7-8yr)
3mo/20day/20day
PCY PowerShares Emerging Mkts Bond (7-9yr)
LQD iShares iBoxx Invest Grade Bond (7-8yr)
TLT iShares Barclays Long-Term Trsry (15-17yr)
TIP iShares Barclays TIPS (4-8yr)
DBA PowerShares DB Agricultural Commodities
XLU U.S. Utilities Sector SPDR

Below is a performance graph of the portfolio (green) versus SPY (SPDR S&P 500 ETF) in purple from the portfolio’s inception until July 31st, 2012. Total returns are similar but a significant drawdown was avoided in 2011:

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