Quantitative Investments: A Momentum Strategy Using U.S. Equity Sectors

Includes: IYH, IYK, IYM, IYW
by: Rajeev Seth

While we cannot forecast returns to stocks on an individual basis, using quantitative investment analysis we can do a better job of forecasting returns to groups of stocks. One such momentum strategy says that if we take a stock universe (say S&P500 stocks) and rank the stocks in it into deciles based on past returns, then in a medium-term period of as long as a year, the top decile of the universe (winners) continues to outperform the bottom decile (losers)

Jegadeesh and Titman (1993) (NYSE:JT) examined a variety of momentum strategies and documented that strategies that buy stocks with high returns over the previous 3 to 12 months and sell stocks with poor returns over the same time period earn profits of about 12% per year.

We can extrapolate this to an investment universe that contains the 10 sectors making up the U.S. stock market. So, I examined the ten sector ETFs representing the entire U.S. stock market provided by iShares finding that momentum works extremely well among industry and sector portfolios. This has also been verified by Moskowitz, and Grinblatt, in "Do Industries Explain Momentum?" Journal of Finance, (1999).

The trading strategy I am suggesting here is that you pick equity sectors with highest momentum (past performance) to go long while selling short the sectors with worst performing sectors. The goal of this strategy is to outperform a simple buy and hold of the U.S. equity market index. Behavioral biases such as investor over and under reaction and confirmation bias help account for this market anomaly which has been well tested.

With the analysis run as of market close on April 23, 2013, the following is the ranking of outperformance of the ten sectors.

Given these results, you would go long IYK , and IYH and sell short or stay out of IYM, and IYW. Expected holding period is 3 to 6 months, before portfolio rebalancing.

ETF Ticker ETF Name % Outperformance
IYM iShares Dow Jones U.S. Basic Materials Sector Index Fund -2.617876772
IYW iShares Dow Jones U.S. Technology Sector Index Fund -2.160881082
IYE iShares Dow Jones U.S. Energy Sector Index Fund 2.495247148
IYZ iShares Dow Jones U.S. Telecommunications Sector Index Fund 5.782450465
IDU iShares Dow Jones U.S. Utilities Sector Index Fund 10.84178052
IYJ iShares Dow Jones U.S. Industrial Sector Index Fund 11.3466158
IYF iShares Dow Jones U.S. Financial Sector Index Fund 12.51877817
IYC iShares Dow Jones U.S. Consumer Services Sector Index Fund 14.34701925
IYK iShares Dow Jones U.S. Consumer Goods Sector Index Fund 16.00750771
IYH iShares Dow Jones U.S. Healthcare Sector Index Fund 18.09322531

A visual verification of the relative outperformance over the last 6 months is shown here:

(Click to enlarge)

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.