The Long-Short US Sector Rotation Strategy

The sector rotation model has a yearly profit of 9.86% (SPY ETF 5.1%) and a Sharpe ratio of 0.57 (SPY ETF 0.25). Maximum drawdown was 46% (SPY ETF 55%). So, the strategy performed about twice as good as a S&P500 index investment using the SPY ETF.

Combining both into one sector rotation strategy

The performance of the two stock sector rotation strategies using long and short lookback periods is nearly identical even if they invest half of the time in different sectors.

With our QuantTrader backtesting software, strategies themselves, can be used like ETFs in new strategies. We call such strategies meta-strategies (or strategy of strategies). Now, if you combine the previous two sector rotation strategies in a single sector rotation model you get a higher Sharpe ratio than the two single strategies.

If I dynamically allocate between the two strategies, then I get an average annual return of 10.5% with a Sharpe ratio of 0.66. During flat to declining markets, in the below charts you can see that the QuantTrader backtest will allocate most of the investment into the long lookback low volatility strategy. During bull markets the short lookback strategy seems to work better.

So, all together you can say that these two SPDR ETF rotation strategies complement each other quite well and it makes sense to use them together rather than only using one single strategy.

Mean reversion sector ETF rotation strategy

Another way to construct sector rotation strategies is to use mean reversion. In finance, mean reversion is the assumption that a stock’s price will tend to move to its own average, over time. When the current market price is less than the average price, the stock is considered attractive for purchase, with the expectation that the price will rise. When the current market price is above the average price, the market price is expected to fall. In other words, deviations from the average price are expected to revert to the mean.

Quant trader can be used to build such strategies with sector ETFs. The idea is that all sectors when averaged, will move in tandem with the market which is represented by the S&P 500. There are however each month sectors which perform much better or much worse than the average.

Normally the market exaggerates to the down- and to the upside moves of the best and the worst sector. There is a good probability that the worst sector will recover slightly from its losses the next month and the best ETF will give away some of its gain due to profit taking. Based on this probability we can now build some mean reversion strategies.

Sub-strategy 3: A U.S. sector rotation “buy the worst” mean reversion Strategy

The “buy the worst” mean reversion strategy works quite well, but it is not something for buy and hold investors. Nearly every month you have to invest in another of the SPDR sector ETFs as you can see in the charts below.

The sector rotation model calculates performance differently than for normal momentum strategies. For this strategy the perforance is calculated like this:

Performance = 10 day lookback performance – 2x 20 day lookback performance

The -2x 20 day performance means that the last month performance of the worst SPDR ETF is multiplied by -2x. If the worst SPDR ETF had a -3% performance, this will result in a positive +6% performance. To this we add the performance of the last 10 days.

The result is that an ETF with a positive convexity is preferred. In the chart below you have the performance curve of two SPDR sector ETFs. The green one goes down linearly but the red one oes down and during the last 10 days shows signs of recovery.

Our formula would select the red chart or sector ETF.

The strategy has a yearly profit of 11.36% (SPY ETF 5.1%) and a Sharpe ratio of 0.64 (SPY ETF 0.25). Maximum drawdown was 47% (SPY ETF 55%). So, the strategy also performed even slightly better than the two momentum strategies.

Mean reversion can also be combined with momentum. The next strategy will do exactly that:

Sub-strategy 4: U.S. sector rotation strategy using momentum and mean reversion

This strategy invests in the best momentum SPDR sector ETF which had a small correction during the last 2 weeks. During bull markets, many investors feel they just missed the opportunity to invest in a good performing sector. Since they do not like to buy at all time heights, they wait until there is a small correction of their favorite industry sector. Then they buy. This is what this strategy does, and it works quite well.
The stock sector rotation strategy has a yearly profit of 12.3% (SPY ETF 5.1%) and a Sharpe ratio of 0.47 (SPY ETF 0.25). Maximum drawdown was 47% (SPY ETF 55%). So, the model performed even slightly better than the two momentum models.

Sub-strategy 5: Short U.S. sector rotation “sell the best” mean reversion model

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