Anatomy of an Investment Strategy, Part III

This is the third part of my series describing my investment strategy. Part I dealt with my overall approach. Part II discussed how I decided to use a thematic index rotation strategy.

Today, I want to explain in further detail the two models I use for thematic rotation. Each model provides monthly signals. One rotates on the basis of market capitalization. The second model rotates on the basis of style. I split the money I manage equally between the two models, using this strategy.

The market-cap model rotates between small-, mid- and large-cap indices. I use the S&P 500 (SPY - commentary - Cramer's Take), the S&P 400 Mid Cap (MDY - commentary - Cramer's Take) and the Russell 2000 (IWM - commentary - Cramer's Take).

The style model rotates between growth and value. For growth, I use a combination of the Russell 1000 Growth (IWF - commentary - Cramer's Take) and Russell 2000 Growth (IWO - commentary - Cramer's Take) or the Russell 1000 Value (IWD - commentary - Cramer's Take) and the Russell 2000 Value (IWN - commentary - Cramer's Take). Both models were originally developed and continue to be maintained by Ned Davis Research.

While it is not central to my investment strategy, I should mention that in order to manage capital gains and losses, I substitute the Russell 1000 (IWB - commentary - Cramer's Take), the S&P 500 Growth (IWV - commentary - Cramer's Take), S&P 500 Value (IVE - commentary - Cramer's Take), the Russell Mid Cap (IWR - commentary - Cramer's Take) and the S&P Small Cap 600 (IJR - commentary - Cramer's Take) for my preferred indices. The ability to realize losses, as in 2008, while maintaining the desired exposure, is an often overlooked advantage of investing in ETFs.

The market-cap and style models each use nine or 10 indicators. Each indicator provides a monthly signal favoring a particular market cap or style. When a majority of the indicators, the weight of the evidence, moves firmly in favor of a particular theme, the model flashes a fresh signal.

The models provide monthly signals, but the holding periods are longer. The market-cap model has an average holding period of five to seven months, while the style model has an average holding period of four to six months. I define this as an intermediate time frame. When I provide monthly updates on the latest model signals, you should not use them for short-term trading.

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At time of publication, Birenberg was long SPY, MDY, IWM, IWD and IVE for client accounts and long SPY, IWM and IWD for personal accounts, although holdings can change at any time.

Steven Birenberg is president and chief investment officer of Northlake Capital Management, LLC. Northlake specializes in managing equity portfolios using a combination of exchange-traded funds and special situation stocks. Birenberg appreciates your feedback; click here to send him an email.