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Beat the Market (Part 6) - Frequently Asked Questions

In this final part of the series we'll look at some commonly asked questions about the strategy.

Andrew

Apr 2, 2021 • 4 min read

What about transaction costs and taxes?

The assumptions I used in backtesting this strategy was a commission per trade of $1. Depending on the broker you use, this might be more or less.

I also don't assume any slippage from buying and selling. From a quick check on the past 30 day median bid/ask spread of all these ETFs, they range from 0.00% to 0.01%, and the average daily value traded is from the hundreds of millions to tens of billions of dollars. So unless you have a very large portfolio, you should be fine.

Unfortunately, I'm unable to comment on your tax situation, so if you need to minimize capital gains taxes for whatever reason, you can try increasing the lookback period to 12 months, which will reduce the number of trades per year to ~2.4 on average.

Does it matter which day of the month you execute the strategy?

Research and my testing have shown that the end of month and beginning of month periods work better than the middle of the month to execute this strategy.

There could be random effects impacting your results depending on exactly which day you use. For our purposes, we are using the end of the month as it's convenient, but if you wish to execute a couple days earlier or couple days later it shouldn't make too much difference.

Will this strategy outperform the S&P 500 every year?

Definitely not. In fact, over the past 18 years, this strategy would have underperformed the S&P 500 ~40% of the time.

And the underperformance can be large – in some years you could be underperforming on the scale of ~20% vs. the SPY (see table below for the annual returns). But over the long term (say on a 5 to 10 year basis), this strategy is likely to beat or even crush the market returns.

Annual returns of the hypothetical backtested Beat the Market (Basic and Enhanced) strategies vs. the SPY (S&P 500 Index ETF), showing many years of underperformance, but a large outperformance during market crashes.

NOTE: This is not financial advice. Results are hypothetical, do not indicate future results, and do not represent returns any investor actually attained. Please read the Disclaimer page for more information.

The real benefit is that you'll get those returns with much less downside risk. In a year like 2008 during the Global Financial Crisis, when the world was falling apart and the market (SPY) was down 36.8%, if you were following this strategy you'd actually be up, beating the market return by an amazing 37% to 64%.

Imagine how much less pain you'd have to go through.

This strategy is likely to be less volatile when there are extreme up or down movements in the market, underperforming during strong bull markets, but massively outperforming during crashes.

It's this smoother compounding that's likely to lead to good outperformance versus the benchmark, and a higher likelihood that you'll be able to stick with the strategy vs. a Buy and Hold one.

Interest rates are so low. Can the TLT still perform?

Yes, we've been in an incredible almost four decade megatrend of declining interest rates.

We've been in an incredible almost four decade trend of declining interest rates, which have been a tailwind to bond prices. (Source: St. Louis Federal Reserve)

Clearly bonds, and especially long duration bonds (such as those the TLT owns), have benefitted from this trend – when interest rates go down, bond prices go up. The longer the bond duration, the more they go up.

Now that we're close to zero, what's the prospect of further rate declines?

Honestly, nobody knows. We are entering an era of the widespread occurrence of negative interest rates in developed market bonds, so theoretically the price of a bond yielding close to zero can still go up if interest rates dip below zero. All the old Economics textbooks have to be thrown out as we've never gone through such a period before.

And what if interest rates trend upwards for decades, as they did from the 1950s to 1980s? Bond prices will clearly be hurt.

You can take some comfort that even during bearish periods (when the SPY is below its 200 day moving average) and rising interest rates, the Beat the Market (Enhanced) strategy will be hiding in short duration Treasuries (SHY), which will be much less affected by interest rate movements, avoiding the bloodshed in TLT thanks to the absolute momentum filter. One caveat is that overall returns are likely to be lower as we will no longer benefit from TLT's favorable returns over the past two decades.

And if we enter a Brave New World and rates keep going even more negative, TLT should do well, the relative momentum component will kick in, and you can benefit from it.

If you're really worried about this issue, just use the Basic version of Beat the Market strategy, which does not use TLT.