The Long-Short US Sector Rotation Strategy

A very interesting strategy is a “sell the best” mean reversion Strategy. This is in fact a short strategy with a negative correlation to the market. Constructing profitable short strategies is very difficult. You have the market with a historical average performance of +5.1% working against you. I tried to use momentum and short always the worst ETF, but this does not work well because of the mean reversion which I used in the last strategy. The best way to short the market is to sell the best performing sector ETF, betting on the fact that it will probably revert to the mean on profit taking.

In the chart below you see the result of the “sell the best” shorting sector rotation ETF strategy.

The sector rotation model has a yearly profit of 1.65% (SPY ETF 5.1%) and a Sharpe ratio of 0.07 (SPY ETF 0.25%). Maximum drawdown was 65% (SPY ETF 55%).
As you can see, the result is quite poor and it would not make sense to invest in such a strategy alone. What makes this strategy very good is that it has a nearly 100% negative correlation to all the long strategies and even with its poor performance you see that the strategy still has long periods where it worked really well. If markets begin to move sideways, the sector rotation model already goes up and this accelerates on down going markets. In fact it is a perfect hedging strategy.

Building a U.S. Sector Rotation meta-strategy using SPDR ETF

A meta-strategy is a strategy composed not of ETFs but of sub-strategies. QuantTrader calculates the performance of a strategy like an ETF. This way you can build a new U.S. sector rotation meta-strategy which is composed by our 5 previously discussed strategies.

We use a lookback period of 116 days and rank our 5 strategies. We limit the maximum allocation for each model to 40% and we calculate each month which asset allocation would have given the best Sharpe Ratio. Adding the short model will most likely increase the Sharpe Ratio more than the other models, because of its nearly 100% negative correlation. This negative correlation will reduce a lot the volatility of the composed meta-strategy.

The chart below shows the result produced by our backtesting software. The middle pane shows you how the asset allocation between the 5 different US Sector rotation strategies changed.

The strategy produced an average yearly profit of 12.8% (SPY ETF 5.1%) and a Sharpe Ratio of 1.16 (SPY ETF 0.25). Maximum drawdown was only 17% (SPY ETF 55%).

Backtest performance overview year 2000- 2017:

SECTOR ROTATION STRATEGY CAGR (COMPOUNDED
AVERAGE GROWTH RATE)
SHARPE (RETURN/RISK) MAX DRAWDOWN
S&P 500 benchmark (SPY – ETF) 5.10% 0.25 55%
1) Momentum long lookback 9.22% 0.58 37%
2) Momentum short lookback 9.86% 0.57 46%
3) Mean reversion “buy worst” 11.36% 0.64 47%
4) Momentum and mean reversion 12.30% 0.47 47%
5) Mean reversion “sell best” short strategy 1.65% 0.07 65%
6) Meta-strategy including strategies 1-5 12.8% 1.16 17%

These backtest results of our sector rotation strategies emplying SPDR ETF are very promising. The backtests included many big market corrections and the sectors cover the whole U.S. market, so there is a low selection bias. The sector rotation models are also quite stable and work with a wide range of parameters with a lot of ETF changes over this long backtest period, so that there is not much danger of overfitting. I use this stock sector rotation strategy myself since quite some time and I think that the probability is high that this model continues to work also well in the future.

Free sector rotation strategy for all our followers

We´re offering this sector rotation strategy permanently for free to all interested followers, no subscription is needed. You can simply register for it from this link and will receive the monthly allocations by email.

Using our QuantTrader backtesting software you can modify this strategy to either fit the ETF provided by your 401k or IRA Roth plan sponsor, or to contribute to the vivid discussion in our QuantTrader forum to further enhance the strategy. Use our QuantTrader 30 days free trial to simulate yours.

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