The Long-Short US Sector Rotation Strategy

The following paper will explain how to build a U.S. sector rotation strategy (a US sector rotation meta strategy combining dynamically 5 different sector strategies based on SPDR ETFwhich allocates dynamically between 4 different long US sector rotation strategies and one short US sector rotation strategy. This strategy is therefore different from our Global Sector Rotation strategy, as it only emplys US sectors.

Due to low correlation of these sector rotations, the combination creates an ETF sector rotation model with considerably higher Sharpe values. The addition of the negatively correlated short sector rotation model significantly reduces volatility and drawdowns during difficult market periods.

The chart shows the portfolio performance (black) compared with the S&P500 index (SPY ETF – red).

The result is a meta sector ETF rotation strategy which performed well since 2000 in the backtests. The Sector rotation strategy produced an average yearly profit of 12.8% (SPY 5.1%) and a Sharpe ratio of 1.16 (SPY 0.25). Maximum drawdown was only 17% (SPY ETF 55%). So, the sector rotation model performed about 4x better than the S&P500.

What makes this sector etf rotation strategy interesting is that it does not rely on either treasuries or bonds to balance out and hedge in times of market stress. It uses the short US ETF sector strategy as a hedge instead. The hedging mechanism is purely “short equity” and unrelated to whether interest rates rise, a common concern when holding bonds in a portfolio.

The U.S. Sector ETF’s – here SPDR ETF

U.S. sector ETFs, based on the Dow Jones U.S. Industry Indices, have been within the first ETFs on the U.S. market. There are sector ETF available from SPDR, Vanguard, Schwab, iShares. There are also European versions of these sector ETFs as well. These 10 Dow Jones U.S. Industry sectors cover about 95% of the US market. Their respective ETFs are highly liquid with small spreads which makes them excellent instruments to build dynamically rebalanced portfolio investment strategies.

For our ETF sector rotation model, we use the Select Sector SPDR ETF, but you can replace these sectors without any problem with the corresponding ETFs or Futures of other issuers. Using our QuantTrader backtesting software you can therefore modify this strategy to fit the ETF provided by your 401k or IRA Roth plan sponsor, use our QuantTrader free trial to simulate yours.
Here are the 10 main U.S. industry sectors currently available with sector SPDR ETF and the corresponding inverse (short) sector ETF with leverage.

SECTOR SECTOR SPDR ETF INVERSE SECTOR SPDR ETF (LEVERAGE) SECTOR FUTURES (GLOBEX)
U.S. Materials Sector XLB ETF SMN ETF(-2x) IXB Future
U.S. Energy Sector XLE ETF ERY ETF(-3x) IXE Future
U.S. Financial Sector XLF ETF SKF ETF(-2x) IXM Future
U.S. Industrials Sector XLI ETF SIJ ETF(-2x) IXI Future
U.S. Technology Sector XLK ETF REW ETF(-2x) IXT Future
U.S. Consumer Staples Sector XLP ETF SZK ETF(-2x) IXR Future
U.S. Real Estate Sector XLRE ETF SRS ETF(-2x)  
U.S. Utilities Sector XLU ETF SDP ETF(-2x) IXU Future
U.S. Health Care Sector XLV ETF RXD ETF(-2x) IXV Future
U.S. Consumer Discret. Sector XLY ETF SCC ETF(-2x) IXY Future

Extended backtest using SPDR ETF since 1999

The Select Sector SPDR ETF exist since 1999. Only the XLRE ETF for the real estate sector was added later in 2015. With the 9 main sector SPDR ETF in existence for nearly 18 years, we can easily perform long-term strategy backtests covering all sorts of economic events, including some important market corrections in 2000, 2008 and 2011.

Due to the small spread of these SPDR ETFs and low fees with good discount brokers we can rebalance our investment monthly at low cost.

For all 10 sectors, we also have inverse SPDR sector ETF. This allows us to short the worst performing sectors. If you use the inverse ETFs, then you have to take into account the leverage of these ETFs and divide your buy orders by 2x or 3x. If you invest using the sector futures, then shorting is no problem at all, however due to the size of the futures which is always around 100’000$ each, you should invest at least 500’000$ in such a strategy to be able to more or less achieve the requested allocations.

Most of our Logical Invest strategies are trend following strategies. This means that we follow longer economic cycles and try to outperform the S&P 500 index by rotating always on a selection of the best performing sector ETFs while avoiding the underperforming sectors.
US sectors are a very good way to do trend following, because each sector normally over- or under-performs for long periods at a time. This also means that over- or under-performance is due to longer lasting economic cycles, not just short term market fluctuations.

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