Sector Rotation

In order to better highlight the principles on which our Premium strategies are based, we will fully detail and track here a simple strategy that rotates at the beginning of every month to the two best performing sectors in the U.S. stock market.

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 strategies.

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)

The rules


  • At the end of each month, RANK the 10 ETFs based on their 6-month 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 in periods of stress

The historical results


The results below underscore that this simple strategy is profitable, and has significantly outfperformed the S&P500 since 2003. 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 less correlated strategies.

Portfolio CAGR Volatility Drawdown Corr. SPY
Sector Switch +18.0% 19.2% -15.3% +0.33
SPY +5.9% 21.4% -52.9% 1.00
Year Sector Switch SPY Overperformance
2003 +27.5% +24.1% +3.3%
2004 +7.5% +10.2% -2.7%
2005 +17.6% +7.2% +10.5%
2006 +22.3% +13.6% +8.7%
2007 +19.7% +4.4% +15.3%
2008 +10.2% -34.3% +44.5%
2009 +28.0% +24.7% +3.3%
2010 +1.9% +14.3% -12.4%
2011 +31.0% +2.4% +28.6%
2012 -1.8% 16.0% -17.8%

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Asset Class Rotation


Now is the time to underscore that monthly rotation between different asset classes is much more powerful that plain U.S. of even global sector rotation, because in the latter case, the ETFs in the universe are highly correlated. When the universe is broadened to encompass all asset classes, this issue becomes less problematic and performance is boosted.
 
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