Weekly Rotating System Between S&P 500 And Utilities (SPY And XLU)

Today we will look at a strategy published by Michael Gayed in his paper An Intermarket Approach to Beta Rotation: The Strategy, Signal and Power of Utilities. Gayed’s paper is among the most downloaded papers on the SSRN website.

The strategy consists of a weekly rotation system between the SPY and XLU based on the past performance of each one. It has outperformed the market since 1926, but the best years seem to have been before the paper was published.

Key Takeaways:

  • A rotation system involves switching investments between sectors or assets, like SPY and XLU, based on their performance.
  • Utilities are chosen for rotation due to their risk-averse nature, low beta, and interest rate sensitivity.
  • The SPY and XLU rotation strategy has historically outperformed the market but showed underperformance post-publication of the strategy.
  • Strategy effectiveness varies with market conditions and may not always lead to superior returns.

What is a rotation system?

In trading, a rotation system is an investment strategy that involves buying an asset, such as a stock or an ETF, and then selling them for another asset. You switch or rotate between different assets.

The idea of a rotation system is that different sectors of the market or stocks perform better at different times, and by rotating between them, we can earn a superior return than just buying and holding the index.

Rotation systems are commonly used in trend following and seasonality strategies. They also tend to be traded weekly or monthly rather than daily.

Why rotate between S&P 500 and utilities?

Gayed argues that utilities are a unique sector because of their risk-aversion, low beta, and sensitivity to interest rates. This last characteristic is because they are driven by the cost of capital rather than revenue growth prospects, given that the federal government limits rate increases to prevent speculation. 

In a falling interest rates scenario, due to recession fears or during periods of significant volatility, utilities tend to outperform the general market because their cost of capital falls. Conversely, utilities tend to underperform when expectations for rising interest rates increase. 

For example, in the 2008 stock market crash, XLU’s maximum drawdown from the peak was -45.2% while the SPY dropped an additional ten points to -54.61%.

SPY and XLU rotating system – trading rules

The trading rules of the strategy are very simple:

Trading Rules

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SPY and XLU rotating system backtest

Before we do our own backtest we would like to show you the backtest result of Mr. Gayed:

SPY and XLU rotating system trading rules

The rotation strategy outperformed massively over the period with the help of compounding the returns. The backtest period covers a lifetime, which might be too long for most of us.

But let’s “zoom in” to find out how it has performed over the last 25 years:

How has this strategy performed since the inception of XLU? We backtested it from 1999, and the data is adjusted for dividends and splits.

The equity curve looks like this:

SPY and XLU rotating system backtest

The strategy metrics and statistics can be broken down into the following numbers:

  • CAGR is 6.05% (buy and hold 6.79%)
  • The standard deviation is 17.1 (18.2)
  • Sharpe ratio is 0.23 (0.24)
  • Max weekly drawdown is -48.9% (-54.6%)
  • Average trades per year are 12.2
  • The percentage of positive weeks is 56.38% (55.83%)

Despite the low CAGR (because we started the backtest almost at the peak of the dot.com bubble), the strategy has performed worse than the market but almost the same if we adjust it for volatility.

However, in Gayed’s paper, the strategy compounded at 13.1% per year since 1929. Does this mean the strategy stopped working?

There is certainly a high possibility. From 1999 until March 2014, when the paper was published, the strategy returned 6.7% per year versus 4.6% for buy and hold. 

But since then, the strategy has lagged the market by more than 5% annually (5.1% vs. 10.4%). You can even see in the chart that the strategy never recovered from the covid crash in 2020 while the market went on to make new highs.

Furthermore, since the peak in 2021, the strategy’s maximum drawdown has been -23.6%, almost the same as SPY’s (-23.9%). 

SPY and XLU rotating system – conclusion

History shows that the SPY and XLU rotating system has performed well. But, as we have seen, the strategy has underperformed the SPY since the paper’s publication. 

However, this may only be a short period of underperformance. Most strategies become less profitable after they are published. It may be too soon to claim that the strategy stopped working.

FAQ:

What is the SPY and XLU rotating system strategy?

The SPY and XLU rotating system strategy is an investment approach that involves weekly rotation between the S&P 500 (SPY) and Utilities (XLU) based on their past performance. The goal is to capitalize on the unique characteristics of the utility sector in different market conditions.

How does a rotation system work in trading?

A rotation system in trading involves buying one asset and selling it for another based on specific criteria. It aims to take advantage of the varying performance of different sectors or assets over time, potentially outperforming a simple buy-and-hold strategy.

Why does the SPY and XLU rotating system focus on Utilities (XLU)?

The strategy focuses on utilities due to their characteristics, including risk-aversion, low beta, and sensitivity to interest rates. Utilities tend to outperform during periods of falling interest rates and underperform during expectations of rising interest rates.

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