Create your own sector rotation strategy

Investors may choose to construct a portfolio that profits from different stages of the business cycle by investing in sectors of the economy that they believe will outperform relative to the wider stock market. We look at the evidence behind sector investing and provide a simple strategy that you can recreate. 

The value of investments can fall as well as rise, and you may get back less than you invested. Past performance is no guarantee of future results

A sector rotation strategy is similar to a tactical asset allocation, where investors look to allocate funds to different asset classes, but rather than picking a combination of equities, bonds and commodities, investors will allocate funds to certain industries.

Identifying the sectors that are likely to outperform is key to beating a buy-and-hold approach, but it is easier said than done. Many market commentators claim you should simply ‘pick an industry that is due for a bounce’ without providing any useful evidence to support their methodology.

Stick to the script

Momentum investing, where investors buy the strongest stocks and avoid the weakest, has been empirically proven to work in sector-based investment strategies over the long run. Nobel Prize winner Professor Eugene Fama who developed the well-known Efficient Markets Hypothesis (EMH), a theory which states that it impossible to ‘beat the market,’ has called momentum the ‘biggest embarrassment to the theory.’

One of the studies that advocates momentum investing comes from Mebane Faber, Chief Investment Officer at Cambria Investment Management, who analysed data for the S&P 500 going back to the 1920s to show a simple sector momentum strategy outperformed a buy-and-hold approach 70% of the time.

The three rules for the strategy are as follows:

  1. When the S&P 500 moves above its 12-month moving average,buy the top three sectors with the largest gains over the previous three months
  2. Rebalance on a monthly basis, selling the sectors that fall outside the top three and buying those who move into the top three
  3. Sell all holdings when the S&P falls below its 12-month average

This strategy has beaten the passive approach by an average compounded annual growth rate of 4.6%.

The third rule that cuts investors out of the market when the S&P 500 (blue line) falls below its 12-month average (red line) has contributed towards the outperformance by reducing both volatility and drawdown. In recent years, investors would have escaped the 2001-2002 bear market and also the majority of the 2008 financial crisis.

Meanwhile, people investing in August 2011 off the back of a buy signal would have generated returns of 62% from simply holding through to August 2015, where the next sell signal was triggered. According to Faber, those employing the above strategy could have earnt returns in excess of this.

While the momentum strategy outperformed a passive approach over the observed period, past performance doesn’t predict future returns and investors must also consider which financial instruments to use and both transactional costs and taxes.

Do it yourself

We believe that exchange traded funds (ETFs) are the perfect product to use to implement a sector-based strategy. This is due to their relatively low fees which minimises rebalancing costs and their transparency allows investors to know exactly what they are investing in. This is essential when identifying the right ETF to use to replicate a certain sectors performance.

If investors wanted to replicate Faber’s findings for US sectors but for companies listed a little closer to home, then ETF provider Amundi offer a series of European sector ETFs. We favour these as they are denominated it sterling which reduces overseas FX charges and also have an expense ratio of just 0.25% which is cheaper than other providers we are aware of.

Oddly though, they do not offer an ETF to track European companies in the technology sector. Instead we suggest using db x-trackers Stoxx® Europe 600 Technology UCITS ETF (XS8R) which is only a touch more expensive at 0.3%.

Or simply let the experts do it for you

Predicting the different stages of the economy is not an exact science and may lead to your portfolio underperforming if you get it wrong. However, sticking to a simple, proven strategy could be more profitable than a buy-and-hold approach over the long run.

If instead you’d like to leave it to the experts, take a look at our IG Smart Portfolios which are managed by BlackRock, the largest asset manager in the world. These are low cost and tailored to your individual risk profile.

1 Faber initially suggested using a 10-month simple moving average as a dynamic hedge but a 12-month average appears to have performed better as it means investors would have not triggered a buy signal during the 2002 bear market and a sell signal during the 2004 bull market.

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