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Strategy’s ‘sweet spot’ for investors

This article is part of
Investing in Passives - September 2016

Strategy’s ‘sweet spot’ for investors

The Rio Olympics was a great celebration of sport. It was also a reminder of just how much of human endeavour, and how much of our natural way of thinking, tends to segregate on a national basis. As with sport, when it comes to investing we also tend to think in national, or at least geographic, splits. 

We tend to form views on the US equity market versus the Japanese equity market, versus the German equity market and so on. Or we may broaden our thinking and consider the European market versus Asian markets, or developed markets versus emerging markets. 

But geographic location is becoming less relevant when it comes to investing. Globalisation is turning the world increasingly into a single marketplace. Since the early 1970s, world trade has rocketed from around a quarter of GDP to more than 50 per cent of GDP today, according to the World Bank. It is important, therefore, to keep in mind that company shares are not de facto shares in a country. Indeed, research shows that the sector a stock is part of is a bigger indicator of potential performance than the country or region the company happens to be based in.

Professional investors have been using sector rotation strategies, which entail taking a view on the prospects for specific industry sectors, for a long time. Sector-based exchange-traded funds (ETFs) have made accessing specific sector exposures very straightforward.

The research paper ‘Sector Rotation: A multi-factor perspective’ published by Deutsche Asset Management, looked at the performance of different sectors on a global basis over time, at how diversified the performance was between sectors, and at how certain strategies rotating between different sectors could be put in place. The research examines a macroeconomic strategy, a valuation strategy, one based on fundamentals, a momentum strategy and a sentiment strategy. It finds distinct performance differences do exist between sectors and that sector rotation strategies may be able to capitalise on them. 

A macroeconomic approach assumes a relationship between sectors and the business cycle. The aim is to identify where the world is in terms of the cycle and which sectors are likely to do well in relation to this. For example, in the early part of the cycle, during the growth phase, sectors such as information technology and financials would be expected to do relatively well, and sectors like energy and utilities to not do so well on a relative basis. Later, during the recession phase, defensive sectors like healthcare would be expected to do relatively better than others, such as industrials. 

A valuation strategy typically attempts to identity the relative ‘cheapness’ or ‘richness’ of each sector based on recognised valuation approaches, such as price-to-earnings ratios. The fundamental approach tries to identify the particular strengths of each sector as measured by the growth of fundamental metrics, such as earnings growth. Momentum focuses on the absolute and relative performance of each sector in recent times – whether the sectors  are moving up or down at a faster rate than other sectors. Finally, the sentiment approach utilises analyst forecasts on each sector to position the portfolio in relation to upwards and downwards revisions to those forecasts.