Sector Rotation based on ETF relative strength is a profitable strategy when correctly implemented. Below is a short article we posted on Seeking Alpha this week-end presenting a simple and fully detailed “Sector Rotation” strategy.
A few months ago, we started a series of articles highlighting the benefits of tactical asset allocation to achieve strong absolute returns with limited risk. (…) The focus of this article is to take a concrete and thorough example of a simple relative strength strategy with a description of the ETF universe and rules used, and how it has performed over the past 8 years. The set of rules is
more simple than the ones we use in our other portfolios and the universe here is only composed of ETFs representing sub-asset classes (sectors) of one single asset class (U.S. equity). Nevertheless, this is quite useful to better grasp the mechanics behind our
1. The ETF Universe: The 10 iShares Sector ETFs
- IDU (U.S. Utilities)
- IYC (U.S. Consumer Services)
- IYE (U.S. Energy Sector)
- IYF (U.S. Financials)
- IYH (U.S. Healthcare Sector)
- IYJ (U.S. Industrial Sector)
- IYK (U.S. Consumer Goods)
- IYM (U.S. Basic Materials Sector)
- IYW (U.S. Technology)
- IYZ (U.S. Telecommunications)
2. The Rules
- At the end of each month, RANK the 10 ETFs based on their 6-month total returns.
- At the close of the 1st trading day of each month, BUY the Top 2 ETFs, except if they closed the previous month below their 6-month moving average. In such case, buy TLT (long-term Treasury bonds) instead.
- REPEAT every month.
In other words, the 6-month moving average filters out the results from the ranking. If none of the top 2 ETFs trades above its moving average, the portfolio is 100% invested in TLT. If only one of the top 2 ETFs trades above its moving average, the portfolio is invested 50% in that ETF and 50% in TLT. If both trade above their moving average, the portfolio is invested 50% in each.
Such a simple system works because of the three main reasons:
- The momentum effect
- The 6-month moving average, which acts as a protection against protracted bear markets
- The negative correlation between U.S. Equities and Long-Term Bonds, especially strong in periods of poor performance of equities (flight to “safety”)
3. The Performance
The results below underscore that this simple strategy is profitable, and has
significantly outperformed the S&P 500 (SPY) since 2003 (the data is as of
November 16, 2011). Also note that all years have been positive since then. As
such, it can be a relevant candidate for consideration for an overall portfolio
strategy. We view its drawdowns and volatility as a little bit too much on the
high side but it may be a useful complement to stock portfolios or less correlated strategies.
To conclude, it is worth noting that this kind of strategy works even better when applied to a universe of different asset classes rather than equity sectors, which are too correlated.