Sector Rotation has been a successful investment strategy for decades. It is simply trading those sectors that have performed the best recently. It relies on what the analysts call “persistence,” the ability for a sector, or any stock price, to continue doing what it was doing before – going up, down, or nowhere at all. It’s also the reason why trend following works. In Chart 1 we can see persistence in Health Care (XLV) which rallied from 2001 to 2007 and again from 2008 to 2014, and in energy (XLE) which has had spectacular ups and downs that seem likely to continue.

Chart 1. Health Care (XLV) and Energy (XLE) sector SPDRs. Data source: CSI.

Sector rotation is a long-term strategy, normally only reviewed one each month, so that many of the small moves that would cause a trader to jump in and out of the market are smoothed over. It looks at the performance of each sector over the past 3 to 12 months, ranks them, and chooses the best three. It turns out that using 3 or 4 sectors in a portfolio gives the best diversification while still allowing investors to profit from big moves. If you over-diversify, you get an average that is much like the S&P index.

The Rules

In its classic form, the rules for sector rotation are:

1. Select liquid sector ETFs. We’ve picked mostly sector SPDRs, but added emerging markets and two Vanguard bond funds, BIV and BND (I’ll explain why in moment.) The list of 14 candidates is shown in Table 1.
2. Calculate the n-month returns for each of the ETFs, where n is from 3 to 12.
3. At the end of each month, replace the 3 previous ETFs with the 3 best currently performing ETFs.
4. Rebalance the size of each position by dividing 1/3 of your investment by the recent price.

Some analysts recommend using a slow trend filter based on the S&P. When the trend is down, we liquidate our positions and stand aside. I like that because you can avoid the large drawdowns of 2000 and 2008. No matter how well you choose the ETFs, you can’t make money being long in a bear market. In our sector rotation program, we’ll use a 3-month moving average of SPY to filter the trades.

Table 1. ETFs used in sector rotation.

 

Choosing a Return Period

Returns over 3 to 12 months is a pretty big window, so which do you use? Three, six, or twelve makes the most sense to me because it will align with quarterly earnings. Results are shown in Table 2 in the three columns on the right and in Chart 2. All tests include the SPY trend filter, so the horizontal periods reflect when we’re out of the market. The best choice is the 3-month return, which is more responsive to changing market conditions.

Table 2. Results of using 3-, 6-, and 12-month returns. Source: Kaufman.

Chart 2. NAVs for 3-, 6-, and 12-month ETF returns, plus returns of the hedged sector rotation. Data source: CSI

Adding a Hedge Position

Most investors have seen that, when the stock market declines, there is a rush to safety, that is, money goes from equities to bonds. We’ve already calculated the trend of the SPY, so it’s a small step to going long bonds when the SPY trend is down and we’re not invested in any other sectors. We’ll take the full investment and divide it equally into long positions in BIV and BND, the Vanguard funds.

If you now look back at Table 2 and Chart 2, you can see that the hedged approach greatly improved on the other tests. Unfortunately, it had more of an impact in 2008 when interest rates were much higher. Recently it has added only a small amount to the downturn in the NAV. But then some positive return is better than none.

 

Should You Invest Now or Wait for Better Performance?

We really have no way of knowing when the market will rally or when performance will start trending up after the recent drawdown. Most investors chase profits, meaning that they wait until they are absolutely sure the trading program is showing strong returns before they enter. With that approach most investors enter at a top and suffer a drawdown before recovering.

Experience shows that entering in three parts spread over time gives an average entry, most often better than any effort to “time” your way into the market. It also gives you a chance to understand the risk of the program, which can only be done when you are actually trading. There are always risks, and both risks and returns tend to get larger over time. It’s unlikely that the chart of NAVs shows the largest risk that you’ll see or the largest return. The good news is that sector rotation has stood the test of time.