Sector Rotation Strategies

Even in the worst bear markets, there are almost always certain sectors that perform moderately well. Likewise, in bull markets, there are always sectors that lead the way with huge outperformance of the market at large. Those facts are what motivates many individuals to pursue a sector rotation strategy. The basic premise is to swap between various sector funds that specialize in a particular industry in the hope of pinpointing the best-performing sector (or sectors) and reaping the benefits.

Frequently used are Fidelity Select Mutual Funds, which include 41 such targeted funds for pretty much every imaginable industry. Fidelity allows unlimited trading (and no loads) with no redemption fees as long as the fund is held for at least 30 calendar days. And if you trade through a Fidelity brokerage account, there are no transaction fees either. With just a $2,500 minimum, the Fidelity Select funds are a great place to find such targeted funds to meet your needs. If you instead want to trade more frequently without restrictions and don't mind transaction costs, there are a plethora of sector-specific ETFs available such as the very popular Select Sector SPDRs. There are even funds that purport to do sector rotation automatically (such as on a quarterly basis) such as Claymore/Zacks Sector Rotation ETF (NYSE: XRO). (XRO, around since September 2006 is down 33% vs. down 32% for the S&P 500. XRO's current allocation is 36% medical, 32% retail/wholesale, 12% finance, 8% business services, and the remainder spread around in four industries.)

Sectors and Stock Market Cycles

Throughout history, there have been sectors that continually perform best during downturns, and sectors that perform best when the market is bullish. In general, it is accepted as truth that stock market cycles precede economic cycles by several months (perhaps six or so). That is, the stock market begins its early bull right before the economy reaches its lowest trough, while the stock market already reaches the middle of its bear when the economy peaks. The basic pattern of sectors goes Financials and Transportation during the early bull of the stock market, then technology, then capital goods, then basic industry at the late bull phase, then energy and precious metals when the stock market is peaking, then non-cyclical consumer goods (i.e. staples) and health care when the market is starting to turn sour, then utilities at the middle of the bear, and finally, financials and consumer cyclicals (i.e. discretionary) during the late bear phrase. See the below chart from S&P for a graphical presentation of this generally accepted cycle. Now, knowing when the "early bull" and "middle bear" start and end is completely subjective and almost impossible to pinpoint.

(Click to enlarge)
Source: S&P
Going back to the point about potential for great performance; if you were able to choose the best Fidelity Select fund annually from 1992-2001, you would have posted an astonishing 66% annualized gain (vs. 12.3% for the S&P 500). But is it possible to know which fund is going to perform the best?

The Strategy

We'll explore a commonly discussed sector rotation strategy using Fidelity Select Sector Funds. I was unable to find a detailed performance analysis of such a strategy, so I sought to find out the performance myself. The basic premise of my analysis goes like this:
  1. Monitor the one month performance of ten broad Fidelity Select Funds: Telecommunications (FSTCX), Industrials (FCYIX), Consumer Discretionary (FSCPX), Technology (FSPTX), Financial Services (FIDSX), Consumer Staples (FDFAX), Health Care (FSPHX), Energy (FSENX), Materials (FSDPX), and Utilities (FSUTX). These ten sectors match the Briefing.com sectors and align with the nine Select Sector SPDRs (with the addition of Telecom). I used stockcharts.com great PerfChart feature to easily compare historical performance over one-month periods (see example below).
  2. Through the last day of the month (e.g. 12/31/2004), determine the two best performing funds. In the above example, Health Care and Consumer Discretionary come out on top. Purchase an equal amount of the two funds on the next business day (e.g. 1/3/2005).
  3. Hold the two funds for 30 days and then immediately sell the shares if the fund isn't still part of the top two. If it is still in the top two, hold onto the shares.
  4. Repeat forever.
This strategy is great because of the low cost associated with the frequent trades. Normally, such high frequency trades lead to an accumulation of sizable transaction costs. But, as I said previously, if you trade these funds in a Fidelity brokerage account, there are no transaction or redemption costs as long as you hold the funds for 30 days.

Now, I must say that this strategy is somewhat counter intuitive to the buy low, sell high mantra. This strategy forces you to buy the "hottest" sector after it's already increased for a month, so you'd potentially expect a pullback. Nonetheless, this strategy is one many investors/traders are interested in, so I used it ignoring the fact that I almost always wait for a slight pullback before pulling the trigger.

Historical Results

I analyzed both the growth of an initial $10,000 investment using this strategy (not including reinvested dividends) as well as the month-to-month percent change and cumulative percent change. I used data from 1/1/2005 to the end of June in 2009. I compared these to a buy-and-hold of an S&P 500 index fund, Vanguard 500 (VFINX). Using the Fidelity Sector rotation strategy, you would have experienced a 30.51% increase, while buy-and-hold of the S&P 500 led you to a 24.11% loss. That is an outperformance of nearly 55%! However, note that the sector rotation strategy was actually at +93% (outperforming the S&P by 65%) as of 10/31/2007, so it actually underperformed the S&P by about 10% from 11/1/2007 to 6/30/2009.

Below is a graph of the growth of $10,000 as well as a cumulative percent change:

Also note that this isn't a true representation of the return on your investment since I left dividends out. When adjusting for dividends, the buy and hold strategy actually returned -17.43% or nearly 7% better. The dividends for VFINX are distributed monthly while the Fidelity Select funds are quarterly. I didn't want to take the huge effort to look up the yields and distribution dates for each particular fund and adjust the results accordingly since it should ultimately be similar to the S&P 500. However, I'd venture to guess that the dividend aspect of VFINX is slightly more attractive than the sector rotation strategy (perhaps by a percentage point or two; hardly enough for it to catch up in this analysis), so that is also something to consider.

For a more detailed month-by-month performance analysis and a list of the funds invested in on any given month, feel free to e-mail me at theinvestingguy@gmail.com, and I'd be happy to send you a copy. Following is a listing of how many months the funds were held: Energy (26 months), Utilities (14), Materials (14), Technology (12), Telecommunications (10), Health Care (8), Consumer Staples (8), Financials (7), Consumer Discretionary (6), and Industrials (4). Not surprisingly, Energy leads the way with its huge run-up in recent years. However, due to this run-up and others, there were several months using the sector rotation strategy that led to huge losses.

Analysis and Conclusion

In general, the sector rotation strategy was far riskier than buy-and-hold with huge fluctuations in return on a monthly basis. See the below graphs for the month-to-month fluctuations in price and notice how the sector rotation strategy is far more volatile than buy-and-hold. Almost without fail, the sector rotation strategy had big gains or big losses every month. I separated them into two graphs since the scales needed to be different in order to more accurately visualize the differences since the past year has been far more volatile in general.




Unlike Sy Harding's market timing STS, this sector rotation strategy is far more aggressive and riskier than buy-and-hold as seen by the above graphs. Mark Hulbert, editor of The Hulbert Financial Digest, further elaborates on this in his New York Times article about sector rotation, saying that "Between the beginning of 1988 and Nov. 30 [2001], the [sector rotation] portfolio outperformed the Wilshire [5000], 16 percent to 13.7 percent, annualized. At the same time, the portfolio was 73 percent riskier than the Wilshire. As a result, the portfolio's Sharpe Ratio was below that of the Wilshire -- which means that it owes its market-beating performance to its riskiness." Thus, sector rotation is not really for investors at all. Rather, sector rotation might make sense for traders who pay close attention to the markets on a day-to-day basis and can stomach additional risk, with the possibility for increased returns.

In the end, while this sector rotation strategy worked for this time period with a huge outperformance on the market, it's probably only suitable for a very small percentage of the population: that is, aggressive traders with long-term outlooks who are able to stomach huge losses with increased risk and pay attention to the market on a daily basis.

5 comments:

  1. Pretty sure that Fidelity Select funds have a 90 day short-term redemption fee.
    Rob

    ReplyDelete
  2. Rob,

    You must be thinking of Fidelity Spartan funds, many of which do have a 90-day short-term redemption fee. The Select funds, on the other hand, all have a 0.75% redemption fee for funds held 30 days or less. For example, check out the Fees and Features tab for the Select Technology fund here:

    Select Technology

    You can view a more complete list of the Fidelity Short-Term Redemption Fee schedules here:

    Fidelity Retail Funds Short-Term Schedule

    Thanks for the comment. Cheers,

    Investing Guy

    ReplyDelete
  3. Beware of Fidelity Netbenefits' estimates of your short/long term shares on your Spartan Index funds. As of 3/23/2011, their online accounting tool has a bug in that it slightly overestimates the number of long term shares. If you try to redeem or exchange the exact amount of long term shares that they report that you have, you could wind up paying a small short-term redemption fee due to their rounding errors. They told me that I should handle the rounding error myself (e.g. by one less share than their tool reports). Excuse me Fidelity but aren't you in the business of financial accounting? They told me they would fix their tool but I am not holding my breath.

    ReplyDelete
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    ReplyDelete

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