Last Updated on 7 September, 2021 by Samuelsson
Investors and traders are always looking for ways to exploit every anomaly in the market to maximize returns, and sector rotation is one of the most common ways they do that. When sector rotation is then combined with sector momentum, it can lead to even better results. Interestingly, both momentum and rotational strategies are simple to apply. But what is sector momentum and sector rotation?
Sector momentum is a sector rotation strategy that uses the concept of relative momentum to boost performance. The idea is to improve trading results by ranking sectors according to their momentum and then buying the best performers while selling the laggards. It is basically where sector rotation meets market momentum.
To help you digest this complex topic, we will discuss it under the following subheadings:
- What is sector momentum, and how does it apply to sector rotation?
- Understanding the idea of sector momentum in sector rotation: what is meant by sector rotation?
- How to identify sector rotation
- How long do sector rotations last?
- How is sector rotation measured?
- Rotation strategy for stocks: how do you find the sector rotation of a stock?
- Using ETFs for sector rotation: the momentum-based ETF sector rotation strategy
What is sector momentum, and how does it apply to sector rotation?
Momentum investing has been around for a long time. It involves going long on stocks or exchange-traded funds (ETFs) that are making higher high and going short the ones that are in a downward trend. The belief is that trends can persist for as long as possible until it has been proven to end. But then, if another asset is showing greater momentum, it would be wise to rotate into that sector and benefit from it.
Now, instead of considering random assets, we consider different sectors and invest in the sectors that are showing the biggest momentum. Then, we review the momentum of the various sector at a specific time — say monthly or 3-monthly — and rotate our capital to the sectors showing the greatest momentum. Remember, there can be momentum in the upward or downward direction. So, our strategy can be long-only, where we seek to only buy top-performing sectors, or a long-short strategy where we long the top performers and short the laggards.
Thus, sector momentum rotation strategy is a form of sector rotation strategy that uses the concept of relative momentum — instead of other parameters, such as the stage of the business cycle — in selecting the sectors to invest in. The concept aims to improve trading results by ranking sectors according to their momentum and then buying the best performers while selling the laggards if possible. It is basically about applying the momentum investing strategy in sector rotation.
As you know, momentum is the most studied concept in trading as it tries to benefit from profitable anomalies in the market. The rotational trading approach, on the other hand, is has been gaining popularity in the equity markets, despite being around for a long time.
Both traders and investors have always known that different industry sectors perform differently in the various stages of the business cycles. So, they have always tried to utilize the different sensitivity by investing in sectors that are most likely to benefit at each phase of the business cycle. And, without any doubt, the approach has been profitable when applied correctly.
However, momentum-based sector rotation has proven to be one of the most successful in recent times. The number of industry sectors in the investment universe has been changing, with new additions being made — for, for example, real estate and telecommunication. But with the original sectors, it has been shown that periodically investing in equity sectors with the highest momentum (the best performance over a specified period) has yielded a better return than the buy-and-hold strategy, which is the objective of any active investing approach.
Understanding the idea of sector momentum in sector rotation: what is meant by sector rotation?
To understand the idea of sector momentum, let’s first understand the concept of industry sectors and sector rotation. There are several sectors of the economy and the market, and they are grouped as follows:
- Consumer Staples
- Consumer Discretionary
- Real Estate
So, there are 11 equity sectors, grouped according to the product or services they offer, and historically, each of those sectors performs differently in different phases of the business cycle. During each of those phases, investors can invest in assets in those sectors, such as ETFs that track the sectors, to benefit from the economic situation of that moment.
By applying the rotational approach, investors rotate their investment capital in and out of the various sectors based on the stage of the economic cycle or the season of the year and the sectors that normally perform better in that period.
But with the sector momentum approach to rotation, investors select the sectors to invest in based on their momentum at the time. The idea is to benefit from the sectors that are performing the most at every point in time. It is well documented that the momentum anomaly, which is usually explained as behavioral investing mistakes such as under-reaction, investor herding/FOMO, and confirmation bias, can be profitable if properly exploited. This anomaly is described by Tobias J. Moskowitz and Mark Grinblatt in their paper titled: “Do Industries Explain Momentum?”
With the sector momentum rotation strategy, the aim is to use momentum to rank each sector and then buy the best performing sectors while probably shorting the laggards. This approach is often called a momentum-based “top N” sector rotation strategy because it uses momentum as the quantitative signal.
Here’s how it is done: use the SPDR sector ETFs to measure the momentum in each of those sectors over a certain period — often 12 months. The ticker symbol of the various sector ETFs are given as follows:
- XLY: consumer discretionary sector ETF
- XLE: energy sector ETF
- XLP: consumer staples sector ETF
- XLF: financial sector ETF
- XLV: health care sector ETF
- XLI: industrial sector ETF
- XLB: material sector ETF
- XLRE: real estate sector ETF
- XLK: technology sector ETF
- XLU: utilities ETF
- XTL: Telecommunications ETF
The next thing is to rank different sectors according to their momentum and then invest in say three sectors that are showing the biggest momentum. You review the momentum of the various sectors every month or 3 months and rotate your capital to the top 3 sectors showing the greatest momentum over the preceding 12 months.
Since momentum can be in the upward or downward direction. You can decide to take only the long play or play both long and short. If you playing the long-only strategy, you only buy top-performing sectors at each rotation. But if you opt for the long-short strategy, you can long the top three performers and short the worst three laggards during each rotation.
How to identify sector rotation
As a retail investor, it is not enough to know whether the market is in a bull or bear condition. If you want to beat the market as some professional fund managers do, you will need to know which sectors are poised to outperform the rest in any given economic condition. When you are good at spotting the emerging winners in terms of industries and front-run it before the big institutional traders come in, you stand a chance to make good profits. For example, if the utilities sector is going to be of interest to the fund managers, you are likely going to make more money with timely purchases of the best stocks in that industry.
To be able to identify the sectors the big boys are going to rotate into before they do, 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.
Certain industries perform better in specific phases of the cycle. For example, consumer staples and health care tend to do well during the recession phase.
But you should go beyond the economic cycle to study the momentum of the various sectors, as the institutional investors do. The easiest way to do that is to study the returns of the ETFs tracking the various sectors over the last 12 months. Also, check the leaders of the industry sectors, and more importantly, monitor the actions of ETF and mutual fund managers to know when they are about to rebalance the composition of their funds.
How long do sector rotations last?
There is no specific time for sector rotation. It all depends on what the institutional traders are doing, which is why you need to monitor the markets for signs of their activities. If you can know when they are dumping a sector for another sector, you can at least jump out from that sector, if you’re in it, so that you don’t get caught up in the blood bath. And if possible, you can front-run them in the new sector they are moving into so that you can gain from their huge buying power.
However, as a guide, many institutional traders who use the sector rotation approach often make use of the economic cycle to determine when they rotate from one sector to another. But there’s no way of knowing how long each phase lasts. For those who use the sector momentum approach in their rotation, it’s typical of them to review the momentum in various sectors every month or every 3 months. But that does not mean that they rotate every 1-3 months, because if there’s no change in the momentum, they will leave things as they are.
How is sector rotation measured?
Sector rotation is best measured with a sector rotation chart, such as the Sector PerfChart from stockcharts.com displayed below:
The Sector PerfChart is used to measure sector rotation within the S&P 500. The default version of the chart shown above measures the performance of nine sector SPDRs relative to the S&P 500. For example, if the S&P 500 has gone up 2.5% while a certain sector has gone up by 5%, then the relative performance of that sector would be +2.5% since the sector is up more than the S&P 500 and outperforming.
Similarly, if the S&P 500 is down by 4.5% while the sector is down by 1.5%, the sector would’ve outperformed the S&P 500 by +3%. The reason is that while both are down, the sector is down less than the S&P 500 and, therefore, holding up better. So, to find relative performance with this tool, you simply have to subtract the absolute gain/loss in the S&P 500 from the absolute gain/loss in the sector you are measuring.
In that chart above, you will see the current relative performance for the nine sectors SPDRs. Notice that 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) seems to at the same level as the S&P 500.
Rotation strategy for stocks: how do you find the sector rotation of a stock?
Of course, you can use a momentum-based sector rotation strategy in your stock trading. However, constructing a stock portfolio based on sector momentum and periodically rotating among various sectors can be very tough. While there are different ways you can implement the idea, you have to be very careful not to concentrate your capital on a few stocks at any point in time so as not to expose your investment to much systemic risk.
To implement a momentum-based sector rotation strategy, you have to deploy a “top-down” approach. What this means is that you measure the momentum of the various industry sectors over a certain period, say 12 months, and rank them according to their momentum — from top performers to laggards.
You then select the top three sectors that are showing the biggest momentum and study the leading stocks in those sectors. You can use momentum to rank these stocks too and invest in the very best-performing stocks.
Now, you can choose to review the momentum of the various sectors and the individual stocks every month or 3 months and rotate your capital to the best stocks in the top 3 sectors showing the greatest momentum over the preceding 12 months. Since momentum can be in the upward or downward direction. You can decide to play both long and short, where, during each rotation, you buy the best-performing stocks in the top three sectors with the highest momentum and short the worst stocks from the worst-lagging sectors. But if you prefer to only play long, you just buy the best stocks from the best sectors during each rotation.
Choosing the right stocks to trade from the best-performing sectors is not an easy one. But there are a few ways you can go about it. For example, you may have to look at their fundamentals and also do some technical analysis. Alternatively, you can just stick to the momentum approach and choose the stocks with the best momentum, as measured by their returns in the chose time frame.
The drawbacks of using the sector rotation strategy to trade stocks
Here are some of the demerits of using the sector rotation strategy to trade stocks:
- There may be too much exposure to systemic risk: It is easy to over-concentrate your investment on a few stocks in a few sectors, and this can expose your portfolio to systemic risks. To avoid over-concentrating your investment on a few stocks, it’s better to use a weighting system in your portfolio, whereby you reduce your positions in the sectors that are out of favor and increase your positions in the sectors that are favored, instead of totally offsetting your positions in one sector and moving fully into another sector.
- You must be right three times to profit from the rotation strategy: Sector rotation strategy for stocks requires you to not only pick the top sectors but also pick the stocks that will rise within those sectors and finally sell them in time before the sector loses favor. Perfectly achieving these three can be tough.
- You may end up in the worst-performing sectors: Sometimes, in trying to pick the winning sectors and staying out of other sectors, you may end up with heavy holdings in stagnant stocks or buy at the very top, which would be devastating to your portfolio.
- Implementing the rotation strategy can be expensive: Anytime you move to a new sector you get charged fees twice since you are charged for selling your positions in one sector and charged again when you buy in the new sector. This may not be a big deal if you use discount brokers, but trading fees and commissions can still add up, eating into your profits.
Using ETFs for sector rotation: the momentum-based ETF sector rotation strategy
The most common way investors implement the sector momentum rotation strategy is by investing in sector-based ETFs, such as the SPDR sector ETFs listed below:
- Consumer discretionary sector ETF (XLY)
- Energy sector ETF (XLE)
- Consumer staples sector ETF (XLP)
- Financial sector ETF (XLF)
- Health care sector ETF (XLV)
- Industrial sector ETF (XLI)
- Material sector ETF (XLB)
- Real estate sector ETF (XLRE)
- Technology sector ETF (XLK)
- Utilities ETF (XLU)
- Telecommunications ETF (XTL)
With this approach, investors aim to concentrate their capital on those ETFs that are experiencing huge momentum by selling the ones with low momentum and buying the ones in good momentum. Here’s how they do it:
Step 1: They will measure the momentum of the 11 sectors ETFs over a specific period. Most times, they use 12 months, but some still use 6 months or 3 months. So, they measure a 12-month, 6-month, or3-month return of the various sectors.
Step 2: They rank the different sectors according to their momentum and invest in the top three sectors that are showing the biggest momentum. For example, from the Sector PerfChart above, the top three performers are utilities (XLU), consumer staples (XLP), and technology (XLK). So, they would invest in these three sector ETFs.
Step 3: They choose how often they rotate their ETFs. It could be monthly, 2-monthly, or 3-monthly. At the end of whatever interval they choose, they would review the momentum of the various sectors again, rank them, and pick the top three performers. So, whichever one(s) of the previous top three that falls out of the position in this present ranking would be sold and the fund used to purchase the new entrant(s) into the top three performers.
One problem with this approach is that it exposes the investor’s capital to systemic risk because the investment is concentrated in a few sectors. So, any market event that affects those sectors can wipe out the investor’s capital, which is definitely not what any investor would want.
To reduce this risk, a good approach could be for the investor to hold a good size of their capital across all the sectors and have another portion set aside for rotation among the top-performing sectors with the highest momentum. For instance, rather than concentrate 100% of their portfolio in the top three sectors, they could spread 50% of their investment capital across all the sectors and then rotate the other 50% among the top three sectors with the best momentum. So, during each rotation at the end of every month or two — depending on their rotation interval — only 50% of their capital would be available for rotation among the top three sectors. They sell the ones that fall out of the top three and reinvest the money in the sectors that replaced them.
This approach may seem very simplistic, but it is not easy to implement. Any investor who wishes to use it must endeavor to backtest it thoroughly and create a reliable trading plan.