The Long-Short US Sector Rotation Strategy

Economic cycle – base for our ETF sector rotation model

The economy itself is not a linear stable system, but swings between periods of expansion (growth) and contraction (recession). This results in a series of “market cycles” which are visualized in the following picture.

Source: http://www.nowandfutures.com (Global Business Cycles)

Each market cycle favors a different industry sector, and the goal of a good working sector rotation strategy is to invest always in the best performing sectors while avoiding or even shorting the worst performing sectors.

An overview of different U.S. sector rotation strategies

In fact there is not only one single trend following strategy possible, but we have different ways to construct sector rotation strategies. To backtest these sector rotation model we use our QuantTrader backtesting software.

Sub-strategy 1: A U.S. sector rotation Momentum Strategy with a long lookback period

This is probably the most basic trend following strategy. The strategy ranks the Select Sector SPDR ETF and every month we invest in the top SPDR ETF for the following month. The image below shows the sector rotation model backtest using QuantTrader (QT). The backtest starts Oct. 29, 1999 until today. QT shows 3 panes. The top pane just shows the different SPDR sector ETFs performances. We did not include the relatively new XLRE ETF sector, but only the 9 basic industry sectors which allows for a longer backtest.

The middle pane shows the monthly changed asset allocation. In fact you see that we only used 6 of the 9 sectors, while more than half of the time the sector rotation strategy was invested in the consumer staples sector (XLP ETF) and also quite often in the utilities sector (XLU ETF ).

The last pane shows the portfolio performance (black) compared with the S&P500 index (SPY ETF – red).
The summary field shows that the sector rotation ETF strategy produced an average yearly profit of 9.22% (SPY ETF 5.1%) and a Sharpe ratio of 0.58 (SPY ETF 0.25). Maximum drawdown was 37% (SPY ETF 55%). So, the strategy performed about twice as good as a S&P500 index investment using the SPY ETF.

The ETF sector rotation model uses a lookback period of 198 days, and a volatility attenuator of 5. These 2 parameters are used to rank the SPDR sector ETFs each month and determine the top sector. The formula used to rank the ETFs is our modified Sharpe ratio which we have first introduced in the Universal Investment Strategy:

We normalize the returns because we want to rank also the SPDR sectors ETFs with negative return. The normal Sharpe calculation (Return/Volatility) can only be used for ETFs with positive return. Normalizing means that we use 1.05 for a +5% performance or 0.97 for a -3% performance. The volatility is normalized the same way.

Volatility attenuator – Modifying the Sharpe Ratio of the sector rotation ETF model

The volatility attenuator allows us to give a weight to the volatility or risk of an ETF. If the volatility attenuator is 1, then we have a normal Sharpe formula with performance divided by volatility. If the attenuator is 0, then we always divide by 1, which means that we rank only by performance and we do not consider volatility or risk. A volatility attenuator higher than 1 means that we rather want low volatility SPDR sector ETFs, but still prefer a good return.

For the strategy, we use a volatility attenuator of 5, which means that we want to select the SPDR sector ETFs with low volatility. The result is a volatility of 15 for this strategy which is lower than the volatility of most SPDR sectors ETFs or the SPY ETF. The lower drawdown of 37% compared to the other sector rotation models is also due to the lower volatility which tends to select safe haven sectors like Consumer Staples (XLP ETF) during market corrections.

Using these settings, this ETF sector rotation model is quite conservative and safe. For some bull market cycles, it is probably a little too safe, therefore we construct a second trend following strategy which is selecting well performing sectors a little bit more aggressively.

Sub-strategy 2: A U.S. momentum based sector rotation Strategy with a short lookback period

This sector rotation model has a lookback period of only 7 trading days. This means that each month it will invest in the best performing SPDR sector ETFs of the last 1.5 trading weeks.

Such a stock sector rotation strategy will automatically result in more frequent rebalancing. You see in the middle pane of the chart above, every single one of the 9 SPDR ETFs was used. This strategy however reacts much faster on market changes than the previous one, and about half of the time the strategy is invested in different sector ETFs than the strategy with a long lookback period.

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