Downward Spiral of Sector Rotation Strategies
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I started?Tuttle Ventures ?in order to help people find lasting financial security.
Newsletter Rundown:
What is a sector rotation strategy and how does it work?
What does the research say about sector rotation strategies?
The Myth of Sector Rotation Strategies
Final Word
What is a sector rotation strategy and how does it work?
A sector rotation strategy is an investing approach that focuses on allocating capital across different sectors of the market. This type of strategy seeks to capitalize on the cyclical nature of sector performance by rotating capital between sectors in order to take advantage of changing market conditions.
In general, sector rotation strategies involve identifying which sectors are performing well and then reallocating resources into those areas while simultaneously reducing exposure to underperforming sectors.
Conveniently, SPDR Sector ETFs provide a full product lineup to support a sector rotation strategy:
The idea is that an investor can benefit from higher returns in those over-performing sectors while also limiting losses if a particular sector begins to decline.
In practice, tracking these 11 ETFs across investor portfolios overtime morphs into a tangled web of dozens of ETFs. Under close scrutiny, positions often contradict what advisors claim about a business cycle at face value.
In 2017, the popularity of sector rotation strategies blew up in the 1-size fits all ETF space.
There are now?19 different ETFs?that attempt to mimic this investment approach.
With a six year track record it is still considered an early investment fad.
What does the research say about sector rotation strategies?
“The Myth of Sector Rotation Strategies” published back in 2008 by Molchanov & Stangl, provides an overview of sector rotation strategies.
This paper uncovers the underlying reasons why sector rotation strategies tend to struggle, presenting three unique findings that shed light on this perplexing dilemma.
The analysis investigated industry performance over 10 National Bureau of Economic Research (NBER) dated business cycles from 1948 to 2018.
The study found: “The significance levels observed are only marginally different from those?expected to occur randomly, without any systematic outperformance…With transaction costs, sector rotation performance quickly dissipates.”
Let’s take a closer look…
#1 Hindsight is 20/20
The key problem with sector rotation strategies is?defining where we currently are in a business cycle and for how long. Typically investors don’t try to claim with any level of certainty a defined business cycle because individual companies have other fundamental components that are meaningful in the long run.
Last month, I asked Twitter where we are in the business cycle, not surprised there was not majority consensus:
Ok, let’s just assume you can get a business cycle perfectly timed right… how long until you have to trade again?
Business cycles are constantly in motion (hence the term “cycle”) and even with perfect timing you don’t have a clear definition until lagging economic indicators many months later come in to justify a period in time for rebalancing.
There is often a lag between economic events – such as an interest rate hike or cut – and the real economy. This can be especially true with monetary policy decisions; investors may think that they are making rational decisions based on current information, but in reality, these decisions may be too late to capitalize on short-term market movements because of the lag in economic data.
Rebalance too late, and you miss a sector rotation entirely, rotate too early and you may sell before a sector even comes into favor.
Even a broken clock is right at least two times during a day.
It’s my opinion that?leading economic indicators?are much more helpful because markets are usually forward looking, and clearly defining a cycle is less important for individual companies.
Look at the correlation of a broad sector rotation strategy ETF?XLSR?0.00?compared to?SPY?-1.15%↓?(0.978) is there really any meaningful statistical difference for an active manager?
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As Bodie, Kane and Marcus (2009) put it: “sector rotation, like any other form of market timing, will be successful only if one anticipates the next stage of the business cycle better than other investors.”
Going back to the original paper, The Myth of Sector Rotation Strategies, the results suggest that no variation of sector rotation provides systematic outperformance, questioning the popular belief that timing sector investments with business cycles generate excess returns.
Na?ve long-only
I’ll admit, there is no shortage of quantitative research in the market to support any pre-existing narrative.
But sometimes an application of common sense is in order.
Think about it, in order to capture the full potential returns of a sector rotation strategy— you need to be able to go long and short the winning and losing sectors.
A recent example of this is last year, when energy was the only positive sector.
Going only long any other sector would have negatively contributed to absolute returns, (if you only stick to the SPDR basket of ETFs)…
If you are only long sectors during an economic slowdown it is like “walking uphill, both ways, in the snow”.
Not every cycle is created equal
Another step in forecasting the performance of a sector rotation strategy is to assess the status of the economy as a whole.
The problem is every business cycle can be dominated by different sector weights, creating outsized effects in one cycle that may not translate to another.
This makes the contribution of historical sector allocations will never have the same marginal contribution to portfolio returns.
The size of pie slices is constantly changing.
For example, look at the change in sector weights for the S&P 500 Index from 2002 compared to 2023.
Going long industrials back in 2002 is starkly different from going long industrials in 2023.
The obvious shift in technology, financials and consumer defensive distorts the starting level of when a sector rotation strategy is put in place.
Capital market assumptions need to address why an initial position is in place for any amount that differs from the benchmark index.
When energy makes up only 5% of the the S&P 500 index, what level of confidence do you need in the business cycle to allocate 50%+ to the energy subsector?
Dismissing technology at a minimum means an active share of 23 in today’s market.
In a paper published by Newfound Research “Using PMI to Trade Cyclicals vs Defensives”?the study used data from the Kenneth French website, and extended a sector rotation study back to 1948, and similarly found that changes in PMI (regardless of lookback period) are not an effective signal for trading Cyclical versus Defensive sectors.
The study concluded,?“We find little evidence supporting the notion that PMI changes can be used for constructing a long/short cyclicals versus defensives trade.”
Sector strategies tend to underperform because they?lack diversification?and miss out on potential returns associated with shifts in sectors or industries between rebalancing periods.
Newfound comes back to suggest: “A more reasonable expectation might be that?Cyclicals tend to outperform Defensives?during an expansion, and?Defensives tend to outperform Cyclicals?in a contraction, but there may be meaningful exceptions depending upon the particular cycle.
Final Word
There is no one-size-fits all approach when it comes to investing; instead investors must carefully evaluate each situation independently before making decisions about whether or not a particular sector rotation strategy makes sense for them. By understanding the nuances, smart investors can evaluate the merits of an active investment strategy.
As most of our readers are aware, we favor bottom up fundamental analysis (i.e., company fundamentals) as well as top down macroeconomic factors in a tandem to create an investment portfolio.
With this combined knowledge in hand— alongside sound investment practices—are essential for any long term investor.
Thank you for reading and I am grateful and humbled to be able to learn, grow and invest alongside you at Tuttle Ventures.
Vision, Courage and Patience leads to successful investing.
Best,
Darin Tuttle, CFA
This is not investment advice.?Do your own due diligence. I make no representation, warranty or undertaking, express or implied, as to the accuracy, reliability, completeness, or reasonableness of the information contained in this report. Any assumptions, opinions and estimates expressed in this report constitute my judgment as of the date thereof and is subject to change without notice. Any projections contained in the report are based on a number of assumptions as to market conditions. There is no guarantee that projected outcomes will be achieved.
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