Last Updated on 10 February, 2024 by Rejaul Karim
Embark on a comprehensive exploration of “US Sector Rotation with Five-Factor Fama-French Alphas” with Sohan Sarwar, Cesario Mateus, and Natasa Todorovic. Across 27 pages, this research delves into the intricate landscape of US sector portfolios, employing the Fama-French five-factor model to unravel the dynamic returns of these portfolios.
The study unveils persistent alphas within US sectors, indicative of sectoral outperformance or underperformance. Notably, a long-only sector rotation strategy aligned with positive five-factor alphas outshines traditional S&P500 buy-and-hold approaches, boasting a Sharpe ratio four times greater.
Further adjustments for economic recessions catapult the strategy to a remarkable ten-fold Sharpe ratio. Join this journey through US sectors, witnessing the strategic prowess of sector rotation strategies illuminated by five-factor alphas.
Abstract Of Paper
In this paper we investigate the risk-adjusted performance of US sector portfolios and sector rotation strategy using the alphas from the Fama-French five factor model. We find that five-factor model fits better the returns of US sector portfolios than the three factor model, but that significant alphas are still present in all the sectors at some point in time. In the full sample period, 50% of sectors generate significant five-factor alpha. We test if such alpha signifies a true sector out/underperformance by applying simple long-only and long-short sector rotation strategies. Our long-only sector rotation strategy that buys a sector with a positive five-factor alpha generates four times higher Sharpe ratio than the S&P500 buy-and-hold. If the strategy is adjusted to switch to the risk-free asset in recessions, the Sharpe ratio achieved is ten-fold that of the buy-and-hold. The long-short strategy fares less well.
Original paper – Download PDF
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University of Greenwich – Business School
Aalborg University Business School
City University London – The Business School
Sarwar, Mateus, and Todorovic unravel the intricacies of US sector portfolios, employing the comprehensive Fama-French five-factor model. Their findings underscore the model’s enhanced fit over the three-factor alternative, yet reveal persistent significant alphas across sectors. In a bold stride, they scrutinize the practical implications, birthing long-only and long-short sector rotation strategies.
Astonishingly, the long-only approach, capitalizing on positive five-factor alphas, triumphs with a fourfold Sharpe ratio compared to the S&P500 buy-and-hold. This victory escalates dramatically in recession-sensitive adjustments, catapulting the strategy’s Sharpe ratio to ten times that of the buy-and-hold.
While the long-short strategy faces greater challenges, the research solidifies the potential of strategic sector rotations guided by nuanced risk-adjusted assessments, offering a roadmap for navigating the dynamic landscape of US sectors.
Q1: What is the main focus of the research conducted by Sohan Sarwar, Cesario Mateus, and Natasa Todorovic in “US Sector Rotation with Five-Factor Fama-French Alphas”?
A1: The main focus is on investigating the risk-adjusted performance of US sector portfolios using the alphas from the Fama-French five-factor model. The study aims to understand the dynamic returns of these portfolios and explores the practical implications for sector rotation strategies.
Q2: How do the findings of the research highlight the significance of five-factor alphas in US sector portfolios?
A2: The findings reveal that the Fama-French five-factor model provides a better fit for the returns of US sector portfolios compared to the three-factor model. Despite this enhanced fit, the study identifies persistent significant alphas across sectors, indicating sectoral outperformance or underperformance.
Q3: What are the key insights regarding the performance of sector rotation strategies based on five-factor alphas, and how do they compare to traditional buy-and-hold approaches?
A3: The research introduces long-only sector rotation strategies aligned with positive five-factor alphas. Remarkably, these strategies outshine traditional S&P500 buy-and-hold approaches, boasting a fourfold Sharpe ratio. Adjustments for economic recessions elevate the long-only strategy to a remarkable tenfold Sharpe ratio, emphasizing the strategic prowess of sector rotation guided by nuanced risk-adjusted assessments.