Last Updated on April 24, 2021 by Oddmund Groette
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 (at least not always), 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.
In this article, we look at different types of 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.
Luckily, there are no hard rules of what works and not works in the financial markets. In some weeks will publish a simple rotation system based on just one simple criterion which has worked very well for over two decades.
What is asset rotation?
Asset 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 very simple strategies based on this idea (yet quite effective):
- Monthly momentum in SPY and TLT
- A monthly momentum strategy in ETFs
- A summary of our free trading strategies
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 (?).
What is sector rotation?
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. An example of a live strategy is here.
Why would you do stock rotation?
If you’re a manager of a warehouse 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 at the end of the day, you save time and money.
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. If your portfolio is not organized properly, you’ll have problems managing your stocks. You optimize your “warehouse” by making sure you at all times have the most efficient stocks in your portfolio. This might increase the churn, but your backtests should give you an indication of both the optimal amount of stocks and the optimal churn rate.
How can you rotate among 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 all the time so only top N symbols are traded (according to your parameters). The number of positions is, of course, completely 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 rotation (the pros):
There are many advantages with rotation:
Stock rotations are easy to implement quantitatively:
The main advantage of 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 some else’s gain! Investors are consistent in making mistakes and stock rotation benefits from this. Stocks get oversold and overbought – we just need a system to benefit from these biases in the market.
Stock rotation is simple:
It might sound complicated, but mostly the rotational strategies can be kept really simple to work. Actually, 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 rotation means 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 rotation (the cons):
The main arguments against stock rotation are these:
Stock 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 rotation means 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 rotation involves 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 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.
It’s possible to develop many strategies based on stock rotation. It doesn’t necessarily involve momentum strategies, it could equally well be mean reversion. The possibilities are almost endless.
Stay tuned, in some weeks we’ll publish a rotation strategy based on a basket of stocks. The system is constantly long N number of stocks based on certain criteria. It’s simple, yet pretty efficient.
Disclosure: We are not financial advisors. Please do your own due diligence and investment research or consult a financial professional. All articles are our opinion – they are not suggestions to buy or sell any securities.