How To Increase Return And Reduce Risk With Sector Rotation

by: Andres Cardenal, CFA

Picking the right stocks is important, but picking the right sector at the right time can be even more crucial in terms of maximizing performance.

Momentum can be a powerful return driver for stocks.

Introducing a quantitative system that rotates among 25 sector-specific ETFs based on momentum-based rules.

Backtesting performance is quite strong in terms of both return and risk.

These kinds of systems can be remarkably useful to evaluate the market environment and make better-informed decisions.

Picking the right stocks in a particular sector is obviously important. However, investing in the right sectors at the right time can have an even bigger impact on returns. In the words of Warren Buffett: "A rising tide lifts all boats".

Even a mediocre stock can deliver substantial gains when the sector is booming. Conversely, when a particular sector is struggling, even the best names in such a sector tend to deliver disappointing returns.

Momentum is a pervasive force in the stock market, meaning that winning sectors tend to keep on winning over the middle term more often than not. There is plenty of statistical research proving that investors can outperform the market by systematically following momentum-based strategies.

In that spirit, the following paragraphs are introducing a quantitative system focused on investing in the best sectors and industries through a combination of momentum indicators.

The backtested performance numbers are quite solid, and the quantitative system outperforms a buy-and-hold approach in terms of both return and risk metrics. Importantly, a quantitative system such as this one can be very effective in terms of analyzing the market environment.

Investing In The Right Sectors At The Right Time

The sector rotation system has an investable universe consisting of 25 ETFs that represent different sectors and industries.

These are:

  • First Trust Dow Jones Internet Index (FDN)
  • iShares Nasdaq Biotechnology ETF (IBB)
  • iShares U.S. Oil Equipment & Services (IEZ)
  • iShares North American Tech-Software (IGV)
  • iShares U.S. Pharmaceuticals ETF (IHE)
  • iShares U.S. Healthcare Providers (IHF)
  • iShares U.S. Medical Devices ETF (IHI)
  • iShares U.S. Aerospace & Defense (ITA)
  • iShares U.S. Home Construction ETF (ITB)
  • iShares US Industrials ETF (IYJ)
  • iShares Transportation Average ETF (IYT)
  • iShares US Technology ETF (IYW)
  • iShares US Telecommunications ETF (IYZ)
  • SPDR S&P Bank ETF (KBE)
  • SPDR S&P Capital Markets ETF (KCE)
  • SPDR S&P Insurance ETF (KIE)
  • Invesco Dynamic Food & Beverage ETF (PBJ)
  • Invesco Dynamic Media ETF (PBS)
  • VanEck Vectors Semiconductor ETF (SMH)
  • Vanguard REIT ETF (VNQ)
  • Materials Select Sector SPDR Fund (XLB)
  • Consumer Staples Select Sector SPDR (XLP)
  • Utilities Select Sector SPDR Fund (XLU)
  • SPDR Series Trust S&P Oil & Gas Exploration (XOP)
  • SPDR Series Trust S&P Retail ETF (XRT)

In order to be eligible, an ETF has to be in an uptrend, meaning that the current market price is above the 10-month moving average. If no ETF is in an uptrend, that share of the portfolio is allocated to the Barclays Low Duration Treasury Bond (SHY) as a proxy for cash.

Among the ETFs that are in an uptrend, the system buys the top 5 with the highest relative momentum. This decision is made through a ranking system that considers total returns over three months and six months, and it includes volatility as a negative factor.

Leaving the mathematical details aside, the main logic behind the system is actually quite simple. The portfolio only buys ETFs that are in an uptrend. Among the ones that are in an uptrend, it looks for the strongest ones based on risk-adjusted returns over the middle term.

The portfolio is rebalanced every month, and the benchmark is the SPDR S&P 500 ETF (SPY).

Since January of 2007 - the first full year in which all of the ETFs are available for trading - the system has gained 225.1%, comfortably beating the SPDR S&P 500 and its cumulative gain of 151.7% in the same period.

Source: ETFreplay

In annual terms, the system gained 10.2% versus 7.9% for the SPDR S&P 500. More importantly, the maximum drawdown - meaning the largest percentage drop from the high - was 34.3% for the quantitative system versus a much larger 55.2% for the ETF that tracks the S&P 500 index.

Source: ETFreplay

In other words, the system produced both higher return and lower downside risk than a buy-and-hold position in the SPDR S&P 500 over the backtesting period.

The Trend Is Your Friend

The main reason why the system has a smaller downside risk than the SPDR S&P 500 is that during deep bear markets, the system tends to gravitate towards low volatility sectors and cash.

For example, from October of 2008 until March of 2009, the portfolio was completely allocated to cash, since all of the sector ETFs were in a downtrend. This degree of protection in times when stocks are crushing is clearly a game-changer in terms of providing capital protection in a challenging market environment.

More recently, however, in January of 2019, the SR system was allocated 80% in cash because most sectors were struggling. But the markets rapidly reversed higher, so the quantitative system underperformed versus buy and hold.

This performance clearly shows that these kinds of systems have both strengths and weaknesses. In times when there are well-defined trends in the markets, either up or down, a system such as this one will most probably deliver attractive returns.

However, in a period in which trends are rapidly changing in direction, the system will probably produce mediocre performance overall. It takes some time for the system to adapt to changing market conditions, since it's based on trend indicators over a middle-term horizon.

It's interesting to note that these kinds of systems can also be valuable tools to evaluate the overall market environment. After a strong rally in January, the SR system significantly increased its risk exposure, indicating that the momentum metrics for different sectors were improving.

In February, the system was allocated to Software (IGV), Medical Devices (IHI), Media (PBS), REITs (VNQ), and Utilities (XLU). The SR system outperformed the benchmark last month, gaining 4.1% versus a net gain of 3.24% for the SPDR S&P 500 during the period.

All of the ETFs in the portfolio contributed with positive returns, with Software and Medical Devices providing a big share of the outperformance during the month.

Source: ETFreplay.

Even if you don't replicate a system such as this one, it's good to know in which direction the momentum indicators are pointing. Information is power in the stock market, and these kinds of systems can provide remarkably valuable information to make better decisions and optimize returns.

Disclosure: I/we 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.