Contrarian Sector Rotation Strategies With ETFs

August 29, 2016

This article is part of a regular series of thought leadership pieces from some of the more influential ETF strategists in the money management industry. Today's article features Ben Doty, senior investment director for wealth manager Koss Olinger of Gainesville, Florida.

Sector rotation has been around for some time as a tactical strategy. This is most evident in the proliferation of ETFs that target sectors—which now number in the hundreds.

A key question for advisors and investors, however, is how to pull these sector options into a workable strategy. Some ETFs are built around sector rotation. For example, the Global X JPMorgan US Sector Rotator Index ETF (SCTO) tactically rotates into and out of sectors based on momentum.

These ETFs, though, are relatively small (SCTO had $13.1 million in assets as of Aug. 24), or may move completely into another asset class, such as cash and its equivalents. State Street also filed recently the SPDR SSGA US Sector Rotation ETF in March.

There Is Another Way

However, a very liquid strategy using high-AUM sector ETFs is very workable to take advantage of the benefits that come with sector rotation. Examined here are a few simple ones with the S&P 500 sectors (prior to the creation of REITs) as base indexes.

Data is available as far back as 1990. Any rebalancing is assumed to occur once at the end of each calendar year. The S&P 500 is the baseline for comparison.

The benefits of equal-weighting the stocks in the S&P 500 is well-documented. Its benefits come from overweighting smaller-cap stocks in the index, selling price gainers and buying price losers in the index at rebalance.

In the same way, the 10 (or 12) of the S&P 500 sectors, instead of the 500 stocks, can be equal-weighted. Since 1990, this strategy has returned 10.08% annually, or 79 basis points more than a similar investment in the S&P 500.

Sector Tilted: Strategy No. 1

As believers in mean reversion and contrarian investing, an alternative to a momentum-based strategy—which is not considered here—is to overweight prior years’ lowest-performing sectors and underweight best-performing sectors.

In this first strategy, instead of a 10% weight to each sector, 15% can be assigned to the top five lowest-performing sectors from the prior year, and 5% can be assigned to the other five sectors that performed better when the portfolio is rebalanced annually. This strategy would have returned 10.22% annually, or 93 basis points more than a similar investment in the S&P 500.

Sector Tilted: Strategy No. 2

Instead of investing in all 10 sectors, one can concentrate in only five. In this strategy, five sectors receive a weight of 20% each. These are the five bottom-performing sectors of the S&P 500 in the last calendar year. This strategy would have returned +10.72% annually, or 143 basis points more than a similar investment in the S&P 500.

These strategies are simple to understand and implement, and are appropriate for investment philosophies that are value-based.

This is also easy to implement across many different ETF issuers. It is important to note that in nine of those 25 full years, the S&P 500 Index outperformed the other strategies.

Just as with other tactical strategies, there are times when these sector rotation strategies work better than others. 

 

S&P 500 Index-Based Returns (1990 to June 2016)*

  Annual Return Excess to Market Weight
Market Weighted 9.29% -
Equal Weighted 10.08% 0.79%
Sector Rotation - Strategy #1 10.22% 0.93%
Sector Rotation - Strategy #2 10.72% 1.43%

*S&P 500 sector total returns

 

At the time of writing, the author's firm held none of the securities mentioned. Koss Olinger offers wealth management and retirement solutions for individuals, as well as investment strategies and turnkey asset management programs for institutions and advisors. The firm's investment strategies are biased toward value-oriented, defensive opportunities. You can reach Ben at [email protected].

 

Find your next ETF

Reset All