Sector Rotation Strategy – What Is It? | Do Stock Rotational Systems Work?
Last Updated on March 3, 2023
Sector Rotation Strategies. Stock and sector rotation happen frequently for several reasons. What is stock and sector rotation, and why do it? Business cycles make different sectors of the stock market perform differently from each other. For example, presumably, cyclical stocks and banks tend to move first after a recession (we have never tested this hypothesis). Because both sectors and asset classes don’t move in tandem, many investors and traders seek to “rotate” among their holdings. This is, of course, no easy task because of the unpredictability of the financial markets.
Stock and sector rotation is when you switch between different asset classes or stocks. In this article, we look at different types of stock and sector rotations and why they make sense. In the stock market, we have momentum and sector rotation (for example between different ETFs like technology and oil), but you can additionally rotate among different asset classes. We also give you practical examples of stock and sector rotation strategies.
Luckily, there are no complex rules of what works and not works in the financial markets. In some weeks will publish a simple rotation system based on just a straightforward criterion that has worked very well for over two decades.
What is sector rotation?
Sector rotation is when you switch between different asset classes. For example, you can switch your assets from stocks to bonds, all depending on different factors and criteria.
Some years back, we published some straightforward strategies based on this idea (yet quite effective), and these strategies can serve as sector rotation strategy examples:
We sell the Amibroker code for the above strategies:
The first two links are very simple sector strategy examples, but yet they work really well. Simplicity beats complexity in trading!
The well-known money manager Meb Faber published on the 6th of January 2012 an article titled “Momentum for Dummies”:
Once a year he rebalanced among ten asset classes: T-bills, US large-cap, US small-cap, EFA, EEM, US 10 Yr, US Corp, GSCI, REITs, and Gold. He buys buy the best performing asset and this has resulted in a solid 2% outperformance on the S&P 500 annually.
Even better, according to Faber, is buying the second-best performer over the last year, the idea being it has moved too much and might be overbought. However, that might be a little data mining (?).
Another form of sector rotation is when you move your capital from one sector to another (in the stock market). For example, you can have a basket between different ETFs like XLV, XLI, XLF, XME, and XLE, to name a few. Based on your backtested criteria, you switch between these ETFs, perhaps even being short. The website The Robust Trader has an example of an ETF rotational strategy.
Why would you do sector rotation? What is the purpose of stock and sector rotation?
If you’re a warehouse manager, you want to keep your stock as small as possible but, at the same time, own the most efficient stock in terms of margins and sales. This increases your productivity and efficiency, you get a very organized warehouse, and you save time and money at the end of the day.
That’s the theory in the world of logistics and how to manage your inventory.
Can you accomplish the same in the stock market? It turns out you can. You can use the same principles more or less the exact same way.
You want to keep as few stocks as possible but at the same time have enough stocks to make sure you have proper diversification. You don’t want to have too many stocks, so you diversify away potential alpha but still enough to manage an efficient “inventory” of stocks.
You want to have as few stocks as possible because of these reasons:
- To minimize slippage and commissions. The more stocks you have, the more orders to send.
- To own stocks that are good and efficient. They serve your purpose in trading.
- To keep your stock portfolio organized. You’ll have problems managing your stocks if your portfolio is improperly organized. You optimize your “warehouse” by ensuring you always have the most efficient stocks in your portfolio. This might increase the churn, but your backtests should indicate both the optimal amount of stocks and the optimal churn rate.
How can you rotate among sectors and stocks?
Momentum trading has proven to be a successful method over many decades. For example, you “look back” six months and rank stocks based on the rate of change during this period: you buy the best-performing stocks and hold them for one month.
At the end of the month, you do another rank and “rotate” by selling out the stocks not in the rank anymore and buying the news stocks made into the top rank.
You rotate symbols constantly, so only top N symbols are traded (according to your parameters). The number of positions is, of course, entirely up to you, and you can keep them in your ranks even if they fall out of your ranks: If you buy the top five stocks, you don’t rebalance as long as the stocks are among the top 6th ranked stocks. This is convenient to avoid excessive turnover and subsequent commissions and slippage. Your backtests give you clues about what is the most rational thing to do.
The main advantages of stock and sector rotation (the pros):
There are many advantages to rotation:
Stock and sector rotations are easy to implement quantitatively:
The main advantage of sector and stock rotation is that you can do it 100% quantitatively. There is no need to read financial papers and guess which direction any financial assets is heading. It’s practically impossible to forecast forex rates, interest rates, CPI, or whatever macro number that is the main focus at any moment. The best guess is that stocks will continue rising over the long-term.
A model needs to be simple for investors to follow, and mechanical to remove subjective decision-making and subsequent behavioral mistakes. By using mechanical strategies we can exploit other investors’ mistakes to soak up the elusive alpha. Someone else’s loss is someone else’s gain!
Investors are consistent in making mistakes, and stock rotation benefits from this. Stocks get oversold and overbought – we need a system to benefit from these biases in the market.
Stock and sector rotation is simple:
It might sound not very easy, but mostly the rotational strategies can be kept simple to work. Many investors dismiss it because they sound too simple and naive. However, Meb Faber has published many solid strategies that are so simple even your grandma can use them.
Stock and sector rotation mean efficiency:
Just like the metaphor with the warehouse further up in the article, you want to keep your inventory as efficiently as possible.
The main disadvantages of stock and sector rotation (the cons):
The main arguments against stock rotation are these:
Stock and sector rotation requires some effort
If you buy and hold, you can do absolutely nothing. It’s the perfect “sit on your ass” investment, as Charlie Munger would say. Stock rotation requires both backtesting and rebalancing once in a while.
Stock and sector rotation mean taxes:
Unless you have your assets in a tax-deferred account, you need to pay taxes on any profits. Taxes are a huge headwind if you want to compound efficiently.
Stock and sector rotation involve commissions and slippage:
You might avoid commissions completely these days, but slippage can’t be avoided. How much is lost in friction? The more frequently you trade, the more you give away.
Stock and sector rotation might be a result of curve fitting:
If something has worked in the past, it doesn’t mean it will work in the future. Any mechanical rule is at the mercy of the market. However, the more simple you keep the rules, the more likely it is to stand the test of time.
Sector rotation example – video
We have made a specific backtest of a sector rotation strategy.
Stock and sector rotation – Conclusion
It’s possible to develop many strategies based on stock and sector rotation. It doesn’t necessarily involve momentum strategies, it could equally well be mean reversion. The possibilities are almost endless. We recommend you check out our free trading strategies and look into the stock and sector rotation strategies section.