Last Updated on 7 September, 2021 by Samuelsson
If you do watch financial news channels, you most likely have heard analysts talk about investors moving money in or out of certain sectors. You might hear something like, “money is flowing out of the technology sector and going into utilities” for example. One strategy that explains this approach to investing is Meb Faber’s sector rotation strategy. But what exactly is it about?
Meb Faber’s sector rotation strategy is an equity investment approach described by Meb Faber of Cambria Investment Management in his research white paper titled: Relative Strength Strategies for Investing. The strategy involves using a momentum-based approach to buy sector-based ETFs that have recently outperformed their peers.
We will discuss this topic under the following subheadings:
- What is investment rotation, and what is a sector rotation strategy?
- Understanding Meb Faber’s sector rotation strategy: what is it?
- How to identify sector rotation
- How is sector rotation measured?
- How long do sector rotations last?
- How to use sector rotation strategy in investing
What is investment rotation, and what is a sector rotation strategy?
Investment rotation refers to the practice of moving investment capital from one sector of the economy or an asset class to another so as to benefit from the prevailing economic situation of each period. It involves selling investments in a certain group of assets and using the proceeds from the sale of those investments to buy securities in another investment sector or asset class. In essence, the approach is a dynamic way to improve investment returns by going for the assets that are favored in each phase of the economic cycle while diversifying holdings over a specified holding period.
A sector rotation strategy, on the other hand, is an equity investing or trading strategy that seeks to exploit the way different sectors of the equity market perform in different market and economic conditions. The strategy tries to capitalize on the theory that not all market industry sectors perform well at the same time. Basically, it works on the belief that different phases of the business cycle tend to different sectors of the equity market, so by moving to the sectors that are poised to benefit in each phase, an investor can improve returns on his equity investment.
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In other words, sector rotation is based on the idea that a well-performing sector will continue to outperform only to fall out of favor at some point in the business cycle and be replaced by another sector in the economy. With this in mind, fund managers try to buy when a sector is about to come into favor and sell them when the sector appears to have reached the peak of its performance and then move the funds to a sector that will be favored next. In essence, these portfolio managers use these strategies to rotate their capital to sectors they feel offer profitable investing opportunities at each moment.
Interestingly, the sector rotation approach has been modified to incorporate the element of momentum when choosing the sector to invest in. Momentum investing, which can be described as another form of relative strength investing, is now at the heart of the sector rotation strategy, as it shows how to invest in sectors showing the strongest performance over a specific timeframe. It was Meb Faber of Cambria Investment Management who, in his research white paper titled “Relative Strength Strategies for Investing”, described a sector rotation strategy that is based on momentum. The strategy involves using the relative strength of the various equity sectors to buy sector-based ETFs that have recently outperformed their peers.
This approach is termed Meb Faber’s sector rotation strategy, and it is becoming popular because it can improve risk-adjusted returns and automate the investing process.
Understanding Meb Faber’s sector rotation strategy: what is it?
Meb Faber’s sector rotation strategy is an equity investment approach described by Meb Faber in his research white paper titled: Relative Strength Strategies for Investing. It is a simple strategy that involves using a momentum-based approach to buy sector-based ETFs that have recently outperformed their peers.
Introducing the strategy
Before Meb Faber’s work, there have been many papers that showed the profitability of momentum investing, also known as relative strength investing. One example of such is the work of James O’Shaunessey in the book titled, “What Works on Wall Street”, which describes the best performing strategies in the last fifty years. The book showed that relative strength strategies were consistently among the top performers. What this means is that investors love to buy the strongest and shun the weakest. As a result, the strong tend to get stronger, while the weak tend to get weaker.
After studying the momentum concept, Mebane Faber, the co-founder of Cambria Investment Management, wrote a white paper titled, “Relative Strength Strategies for Investing.” In his work, he studied the market’s industry sector data all the way back to the 1920s and found that with a simple momentum strategy, one can outperform the buy-and-hold strategy about 70% of the time.
To put it differently, buying the industry sector that shows the highest momentum outperformed the buy-and-hold strategy over a test period of more than 80 years. Faber noted that the strategy performed very well for 1-month, 3-month, 6-month, 9-month, and 12-month intervals. Additionally, he noticed that one can improve performance by adding a simple moving average to indicate the trend direction taking a position.
The details of the strategy
Now, let’s take a look at the details of the strategy Faber described in his white paper:
The first thing to note is that while the strategy is based on monthly data and the portfolio is rebalanced once per month, analysts can use any day of the month: the first day of the month, the last day of the month, or a set date every month.
The key point of the strategy is to go long when the S&P 500 Index is trading above its 10-month simple moving average (SMA) and get out of the market when the Index is trading below its 10-month SMA. With this basic trend-following technique, the investor should be in the market when there is an uptrend and out of the market when there’s a significant downtrend. For example, the technique would prevent the investor from being in the market during the post-dotcom bear market in 2001/2002 and the great recession of 2008, as shown in the chart below:
Note that Faber used only the 10 industry sectors from the French-Fama CRSP Data Library in his backtesting. The sectors are as follows:
- Consumer Non-Durables
- Consumer Durables
You should note that “Other” includes Mines, Construction, Transportation, Hotels, Business Services, Entertainment, and Finance. Also, instead of searching for individual ETFs that match these sector groups, the strategy simply used the nine sectors’ SPDRs.
Another key part is in choosing the period over which the performance is measured. It can range from one to twelve months; however, one month may be a bit too short, leading to frequent rebalancing. On the other hand, twelve months may be too long, causing you to miss much of the move. A fairly optimal compromise will be to use three months. So, the performance is measured as a three-month rate of change, which is given as the percentage gain over a three-month period.
The next factor to consider is how much to commit to the strategy and how to allocate them to each sector. Whatever amount you choose to commit to the strategy, the common practice is to purchase the top three sectors and allocate equal amounts (33% of the whole amount) to each of the three sectors. You could also use a weighted approach whereby you assign the biggest amount to the top sector and lower amounts in the subsequent sectors.
The trading rules are as follows:
- The buy signal: Buy the top three sectors with the biggest gains over a three-month timeframe when the S&P 500 Index is trading above its 10-month simple moving average.
- The sell signal: Sell all positions anytime the S&P 500 Index falls below its 10-month simple moving average at the month’s close.
- Rebalancing criteria: Rebalance the portfolio once per month by selling sectors that fall out of the top three and buying the sectors that move into the top three.
How is sector rotation measured?
One simple way to measure sector rotation is with a sector rotation graph, such as Sector PerfChart, a simple tool created by StockCharts.com. See it in the picture below:
This tool is used to measure the sector rotation of the SPDRs within the S&P 500 Index. The default version is shown in the chart above, and it measures the performance of nine sector SPDRs relative to the S&P 500 Index.
Here’s how to interpret it: If the S&P 500 Index is up by 2.5% when a certain sector has gone up by 5%, the relative performance of that sector would be +2.5%. What this means is that the sector is outperforming the S&P 500 Index.
In the same way, if a sector is down by only 1.5% when the S&P 500 Index is down by 4.5%, that sector would’ve outperformed the S&P 500 by +3% because while both are down, the sector is down less than the S&P 500 Index. So, we can say that the sector is holding up better.
As a rule, to find the relative performance of any sector with this tool, you simply have to subtract the absolute gain/loss in the S&P 500 Index from the absolute gain/loss in that sector you are measuring.
Take a look at that chart above; you will see the current relative performance for the nine sectors SPDRs. The Utilities SPDR (XLU), Consumer Staples SPDR (XLP), Technology SPDR (XLK), and Consumer Discretionary SPDR (XLY) are outperforming (leading), while energy sector (XLE), Financial sector (XLF), Industrial sector (XLI), and material sector (XLB) are underperforming. The health care sector (XLV), on the other hand, seems to at the same level as the S&P 500.
How long do sector rotations last?
The impact of sector rotation on the market has no particular duration. The state of the market often depends on what the institutional traders are doing, so you have to keep watching the markets for signs of institutional buying or selling in different sectors. Knowing when institutional investors are dumping one sector for another sector allows you to at least jump out from that sector so that you don’t get caught up in the blood bath. And then, when possible, you can front-run them in the new sector they are moving into and benefit from their huge buying power.
Nonetheless, many institutional traders use the sector rotation approach that is based on the economic cycle. So, the duration of each phase may determine how long sector rotations can last. But there’s no way of knowing the duration of the different phases of the economic cycle. Investors who follow the momentum approach in their rotation tend to review the momentum in various sectors every month or every 3 months. In that case, sector rotations may last that long. But this may not always be the case.
How to identify sector rotation
It is not easy to identify sector rotation in action in the market, but as a retail investor, you may need to do that if you want to front-run smart money in their game. The truth is, if you want to beat the market, you will need to know which sectors are poised to outperform the rest in any given economic condition. Your ability to identify the emerging winners in market sectors and front-run it before the big institutional traders come in will enable you to make good profits.
However, to be able to identify the sectors the smart money are planning to rotate into, you need to first understand the economic cycle. A typical economic cycle consists of an early-cycle phase, a mid-cycle phase, a late-cycle phase, and the recession phase, as shown in the picture below:
As you know, certain industry sectors perform better in certain phases of the economic cycle. For instance, consumer staples and health care tend to do better than most sectors during the recession phase.
Apart from understanding the economic cycle, you need to study the momentum of the various sectors so that you can see what the institutional investors see and be able to trade in their direction. One way to do that is to study the returns, over the last three months, of the ETFs tracking the various sectors. Another thing is to check the leaders of the industry sectors. But more importantly, you need to watch what ETF and mutual fund managers are doing to know when they are about to rebalance the composition of their funds. That can give you a clue about the next sector rotation.
How to use Meb Faber’s sector rotation strategy in investing
To understand how you can implement Meb Faber’s sector rotation strategy, let’s take another look at the StockChart’s PerfChart picture and see how we can trade the sector ETFs with positive momentum relative to the S&P 500 Index. See the chart below:
The chart shows the momentum of nine sector ETFs relative to the S&P 500 Index. From the chart, you can see that the momentum was measured over a period of three months: from July to October. In the order of their relative momentum, the sectors shown are as follows:
- Utilities ETF (XLU): +11.91%
- Consumer staples sector ETF (XLP): +7.86%
- Technology sector ETF (XLK): +5.54%
- Consumer discretionary sector ETF (XLY): +2.77%
- Health care sector ETF (XLV): +0%
- Energy sector ETF (XLE): -2.29%
- Industrial sector ETF (XLI): -5.72%
- Financial sector ETF (XLF): -7.37%
- Material sector ETF (XLB): -8.9%
Now, let’s say you are starting with a $12,000 capital and your trading rules are as follows:
- Buy the top three sectors with the biggest momentum when the S&P 500 Index is trading above its 10-month simple moving average.
- Sell all positions anytime the S&P 500 Index falls below its 10-month simple moving average at the month’s close.
- Rebalance the portfolio once per month by selling sectors that fall out of the top three and buying the sectors that move into the top three.
If we assume that the S&P is trading above its 10-month simple moving average, you would buy XLU, XLP, and XLK ETFs, allocating your capital equally among the three. That is, you allocate $4,000 to each of XLU, XLP, and XLK ETFs. After one month, if the S&P 500 is still above its 10-month SMA, you check the momentum again: if any of those three ETFs have fallen out of the top three, you sell that one and buy the one(s) that replaced them in the top three.
There’s one problem with this approach though: it concentrates all your capital in just three sectors, so you are exposed to systemic risks. To reduce the risk, you can use a weighting method and spread your capital across all the sectors, assigning the biggest weight to the sector at the top and the least weight to the sector at the bottom.